I admire the Federal Deposit Insurance Corp., under the leadership of Sheila C. Bair, for taking the lead in attacking the source of the financial crisis: the vicious cycle of declining home prices and foreclosures. I share FDIC's view that the way to break that cycle is to modify mortgage contracts in ways that enable borrowers in distress to return to good standing and stay there -- and to do enough of them to make a difference.
The FDIC plan has two major provisions: a risk-sharing arrangement whereby the government would absorb up to 50 percent of the losses in the event of a second default, and a modification that would reduce the borrower's monthly payment to 31 percent of income.
In my view, the FDIC model falls short for three reasons: It does not target negative equity, it is unlikely to induce servicers/investors to modify more loans, and it provides no way for government to get repaid.
· The model does not target negative equity. Negative equity is when the loan amount exceeds the value of the property. It's what's called being "upside down."
There is a lot of wishful thinking that holds that as long as borrowers can afford the payment, they will continue to pay, without regard for their negative equity. That may have been true historically when negative equity was unusual. There is mounting evidence, however, that substantial negative equity causes some borrowers who can afford their payments to default.
Further, negative equity has enormous social costs beyond the impact on foreclosures. Borrowers with negative equity have no mobility; they can't move to where the jobs are without defaulting on their mortgage. Members of the armed forces with negative equity are a particular source of concern because their transfer to another base almost invariably results in default. Borrowers with negative equity also are likely to cut their discretionary spending, which is bad news for an economy in recession.
The FDIC plan would not require balance write-downs, and its recently released loan modification program guide indicates that it views balance write-downs as the last resort in making payments affordable. In its proposed sequence of steps to get the expense-to-income ratio down to a targeted level, balance reduction comes into play only when the combination of rate reduction and term extension is not sufficient.
I have been told that the FDIC avoided balance reductions because they are prohibited on loans that go into mortgage-backed securities. However, while it is true that most pooling and servicing agreements that govern the actions of firms servicing loans in security pools do not explicitly authorize balance reductions, the trustees that represent the interests of investors can authorize them. If necessary, government could pass legislation that protects servicers from legal liability if they accept balance reductions that in the best judgment of the servicer are in the interest of investors.
· The model is unlikely to stimulate many more modifications. Under the FDIC plan, loss sharing is scaled down from 50 percent to 20 percent as the ratio of loan balance to property value increases from 100 percent to 150 percent. Above 150 percent, there is no loss sharing. Furthermore, the plan does not cover losses on re-defaults unless the modified loan has performed for six months or longer.
These restrictions raise a serious question as to whether servicers and investors will be motivated to modify more loans than they would have otherwise. This is particularly true of the many loans today with high balances relative to property value. That's because re-default rates on such loans are likely to be high; the government's loss share will be low; and a high proportion will occur in the first six months, when there is no loss sharing at all.
The FDIC would require that servicers who modify one loan under the plan modify all their loans, discouraging servicers from picking and choosing the loans to modify. But this "all or none" requirement could result in their choosing none.
· The model has no recovery of government outlays. Under the FDIC plan, none of the dollars paid out by the government to cover losses on re-defaults are going to come back. Presumably, this is why the FDIC felt it necessary to restrict loss sharing.
A successful government plan should:
· Require a write-down of loan balances on all modified loans with negative equity.
· Give incentives to servicers/investors to modify more loans through government contributions to write-downs.
· Remove concerns of servicers/investors about re-defaults by providing complete insurance coverage on modified loans.
· Provide a mechanism for the government to recover its outlays when the economy has turned around and the government has to reduce its deficit.
· Ensure that it is administered effectively by shifting a major part of the workload from understaffed mortgage servicers to other sectors with excess capacity.
On my Web site, http://www.mtgprofessor.com, I lay out in detail a plan that meets all five of these tests. Under the "public policy" section, click on the article titled "Breaking the Back of the Financial Crisis."