A Win-Win Strategy to Mitigate Foreclosures with Minimal Taxpayer Exposure

Foreclosures accelerate the falling prices for real estate and mortgage backed securities and are causing a vicious cycle of distress throughout the financial system. Mortgage foreclosures and write downs of mortgage debt deplete Tier 1 Capital which reduces bank lending. This leads to reduced business activity and increased unemployment which leads to further defaults and foreclosures. As foreclosures increase and neighborhoods deteriorate and unemployment rises, the damage will likely be more than economic.

 

The Federal government should make work out loans available to distressed homeowners enabling them to make payments on their existing mortgages at virtually no risk to the government or taxpayers. The proposed work out loans would be financed by Treasury Notes securely collateralized with a portfolio of first-lien loans with a conservative loan to value ratio. These work out loans places a far smaller burden on the Treasury, at a lower risk to the taxpayer and with greater impact in mitigating foreclosures than other plans currently circulating. Other plans ask the taxpayer to pay for losses from imprudent lending and borrowing practices.

Unless swift action is taken to formulate an effective policy response that prevents new foreclosure filings, the real estate market is set for another round of precipitous declines. The overhang of unsold inventories of homes and the forced dumping of foreclosed properties would dramatically depress real estate prices.  This could contribute to a severe recession that triggers defaults on Credit Default Swaps and could cause yet another shock to the financial system. Nearly a million homes were sold through foreclosure this year. Twice that number are currently somewhere in the foreclosure process. In addition, interest rates reset in 2009 on subprime and Alt A variable mortgages will trigger a new round of foreclosures.  According to Moody’s, as many as 7.3 million homeowners are expected to default on their mortgages within the next two years. Our proposed work out loans should be a key part of any policy response.

The issuance of US Treasury First Lien Mortgage Notes, as we propose, would give policy makers a simple and systematic way to prevent foreclosures in the current environment. These loans are fiscally prudent, politically acceptable and can be implemented immediately under existing law and with funds already authorized by TARP.

Under the new program, government backed loans to provide work out capital to protect distressed homeowners from foreclosure, would go into a capital reserve in an interest bearing escrow account which could be drawn upon to make payments on existing mortgages and prevent loan delinquencies.  This option would be attractive to homeowners wanting to keep their homes and to mortgage holders.  Professor Nouriel Roubini, of the Stern Business School at NYU, estimates, that foreclosure recoveries are averaging 30% in some markets.

The work out loans would be issued for an amount of no more than 40% of the existing mortgage. They would be collateralized by a first lien interest in the real estate to insure full protection to the taxpayer. The existing mortgage holder would be required to agree to subordinate their mortgage.  In exchange, workout capital would be available to service the existing loan.  This would prevent an immediate and substantial cash write off from foreclosure.  The mortgage holder could keep otherwise bad loans on their books generating cash flow.  As a result of this program, mortgage backed securities, containing a portfolio of mortgages, can be maintained in “hold to maturity accounts,” without taking large losses for loan impairment. A bank would be required to certify that a homeowner was in diminished financial circumstances to qualify for a loan.  The mortgage owner and their agent the loan servicing company would have the option to participate.  The program could be open to unemployed or underemployed homeowners who do not have significant assets, as well as homeowners with regular incomes who cannot afford increased payments from mortgage price resets. With the amount of the loan capped at 40% of the principal amount of the existing first mortgage, there should be more than sufficient collateral. However, new appraisals could be required as appropriate.

The interest rate for seven year loans would be set at 260 basis points above 10-year Treasury bonds. (This rate is 100 basis points more than the 160 basis points historical spread of 30-year fixed rate conforming mortgages over Treasuries.) The loan portfolios could be purchased by the Treasury with cash or in a swap for Treasury Notes. This interest rate on the loans would provide funds to cover interest on the Treasury Notes, pay transaction costs and cover any losses, while providing a concessionary interest rate to homeowners.

The loans could be rolled up into a seven year US Treasury First Lien Mortgage Note that would be offered at a discount and not pay a coupon.  Unlike existing mortgage backed securities, these workout capital loans would be transparent and fully collateralized. Conforming programs could be offered in other nations with strongly collateralized real estate loans rolled up into an instrument similar to Brady Bonds. This could be attractive in Eastern Europe, Britain and Spain. Work out capital would be used by distressed homeowners to make mortgage payments on their present mortgage under existing terms or as part of a renegotiation with mortgage service providers. These revised terms could provide interest rate and/or principal reduction to prevent homeowners with negative equity from walking away from their homes. The homeowner and mortgage service provider would negotiate the terms of any new payment schedule and the use of escrowed funds. The escrowed funds could be used to pay the mortgage in its entirety or to pay for alternate months, with the homeowner also making bimonthly payments. The mortgage holder might agree to defer some principal payments and lengthen the term of the loan.

In a typical case, our proposed plan would provide assistance to homeowner X, with a mortgage of $200,000 who is facing distress in meeting payments. Under the proposed program, homeowner X would borrow $80,000, which would be escrowed for the sole purpose of making mortgage payments if he could not. The government would take a first lien for $80,000 and the existing mortgage holder would subordinate its own first lien interest in consideration for the assurance of timely mortgage payments.   In subordinating first position on $80,000, the mortgage owner would be guaranteed to receive $80,000 from the escrowed funds, plus additional payments made by the homeowner. Loans would start coming due after a seven year period. This would provide homeowners ample time to sell the property or refinance. This would also allow homeowners and financial institutions to hold real estate based assets until an economic rebound strengthens the real estate market. Preventing foreclosures and directly supporting real estate prices has not been a priority of policy makers thus far. This potentially catastrophic oversight must be corrected Michael Jaliman is a Senior Adviser with Vantage Partners [email protected]

16 Responses to "A Win-Win Strategy to Mitigate Foreclosures with Minimal Taxpayer Exposure"

  1. Guest   October 30, 2008 at 11:06 am

    What if homeowner X doesn’t deserve to be helped?

  2. Guest   October 30, 2008 at 11:23 am

    I see how the plan would delay or slow down the rate of declining home sales prices, but does not take care of the unlining problem that the home values are out of line with home prices. The values are the real worth– not the current-over-inflated speculatived sales price that have been inflated by nothing down and low interest. It is unreasonalbe and unethetical for the govt. and banks to have over 50% of a family income on home debt service. They can call it compassionate lending, we feel for you or whatever, but it’s just a house of card waiting for the last fool stuck with the house. Dave

  3. ex VRWC   October 30, 2008 at 11:32 am

    So this plan would loan more money on the property, from the Treasury in order to make the payments on the existing loan, and hope the house appreciates in time before ‘the mother of all resets’ so everyone can be paid back. And what if it doesn’t appreciate? It seems to me the net result of the case presented above would be:- The homeowner now has $80,000 less interest in the house, diluting the value of his ‘home ownership’, but he still owes the full amount. Why not just rent?- The original mortgage owner now is behind the government in collecting, diluting the value of his mortgage- The government essentially makes interest payments to the bank in this scenario- If the homeowner walks away, now both the government and the original mortgage owner loseNot sure I see the point in this.

  4. JohnRyskamp   October 30, 2008 at 11:50 am

    Mr. Jaliman is an airheaded technocrat who knows nothing about the law. Notice the out of date “win win” b.s. in his title.What he never talks about–because he knows ABSOLUTELY nothing about it–is rights. Is there anything in this which gives homeowners the RIGHT to demand this protection?And of course, the comment above is correct. What if the economics don’t work out, then what? What exactly keeps the homeowner from walking away.Know what the problem is? The problem is that nothing compels the political system to actually look at ALL the facts of these situations. Who, exactly, IS this homeowner? What is her/his job, income, demographics?It shows a lack of concern for, or even knowledge of, housing, and shows a power-hungry technocract looking to gain power in the political system. Just like Nouriel.Where does he pick up the zombie commentators on this site? from his parties?More top down, highhanded, police state arrogance, without any interest at ALL in how this little plan affects how people actually live.Has it occurred to this giddy clown that we simply ought to ban housing evictions, work from that principle (no involuntarily deprivations from housing) as a human right, and then subordinate any other other considerations to that right?No, because Jaliman, like Nouriel, knows nothing about rights and cares nothing about them.So watch out for these “win win” types–they are ALL agents of the police state. Their agenda is their own careers, NOTHING else.

    • Anonymous   October 30, 2008 at 1:05 pm

      Ban housing evictions? I actually agree with you that if our government had made this a priority in the early stages of this financial debacle, we most likely would have avoided much of the damage from the financial snowball that is now getting larger and larger as it rolls down the mountain!

  5. Anonymous   October 31, 2008 at 8:02 am

    please clarify what you mean by ‘banning housing evictions’… does this mean those people who default on their mortgages do not have to leave?

    • John Ryskamp   November 1, 2008 at 12:13 pm

      That’s right. If it means taking their assets into receivership, garnisheeing their wages, fine. But they must not be removed from the housing they now occupy.It’s coming. Finally, it will be understood that the real economic damage comes, not from unsound mortgage writing, not from default, not from a credit crunch.It comes from people have to leave housing.Look at the facts: the Federal Government now controls or owns ALL the housing in the United States, through its tax policies, its subsidies, and all the corruption it fosters.So the real question is: do we want people housed or not?So now let’s hear from the “punishers”–people who want people kicked out of their housing regardless of the consequences.Sooner or later it will be realized that there is no economy anymore–“economy” is a word which will never have any meaning again. All we have is particular facts, such as housing, or medical care.The police statists will come down on the side of attempt to alter those facts. Those who feel that the individual is all, will say that the law is one thing and one thing only: the maintenance of important facts.That’s the terms of the debate. That’s the struggle. And if you don’t think so, just look at the way Bernanke and Bair are creeping up to–and then running away in alarm–from the idea of increasing level of scrutiny for housing from minimum scrutiny to direct scrutiny. It’s just a SMALL increase in the level of scrutiny for housing. It’s not intermediate scrutiny, it’s not strict scrutiny.But no–the idea that the political system will give up ANY power over housing is still unacceptable to the political system. They think they can get over this crisis without giving up any power.Hell, so does Nouriel. Check his “best and the brightest” approach, and that of all of his minion commentators. These goons are still technocrats out Godard’s “Alphaville.” They still want to twist knobs–and THEY want to be the ones twisting them.If you notice, the current debates have nothing to do with YOUR rights, they have nothing to do with YOU. It’s all about vying for control of a political system which presumes to assert absolute control over ALL facts.And check out the pathetic result: all Nouriel’s idiotic ideas have done, is the hasten the liquidity trap in which the United States now finds itself.EACH and EVERY proposal you read, does NOTHING but plunge the United States further into the liquidity trap.Nothing will stop that downward spiral except banning housing evictions.Why? Because only a housing eviction ban restores confidence in a FACT: people will remain in the housing they occupy, and they will have the power to enforce that rule.At that point, you can begin to plan and invest, because you know that, no matter what else happens, people will remain housed. That is predictable, that is stable, you can count on that.That is what the new bill rights does: it creates confidence. So check out my wonderful book, John Ryskamp, The Eminent Domain Revolt.And don’t be so worried about retaining whatever police state power you now exercise: it will feel good to get rid of it, and exchange for it your individually enforceable power over important facts.Try survival! You might actually get to like it!

  6. Anonymous   October 31, 2008 at 8:38 am

    The answer is to have the government declare CDSs null and void as they are against the public interest in cases where the CDS buyer has no vested interest and is merely speculating. End of crisis.

  7. walt   October 31, 2008 at 9:29 am

    Yes, we have bound up the financial system by not admitting that the gains in the price of houses during the last 10 years are largely an illusion. We cannot avoid goring somebody’s bull to create another illusion of ‘win-win.’ It is probably illegal to declare CDSs ‘null and void’ by fiat, but we can require that they be ‘marked to market,’ where they will be declared worthless.

  8. Steve Walsh   October 31, 2008 at 11:15 am

    ALL the housing market needs is lower rates. In the midst of serious global deflation, 6.5% mortgage rates are absurd. IF the Feds can get mortgage rates down to 5% for 7 to 10 years, with interest only payments, the average household would save $700/month. They should also let homeowners refinance regardless of loan to value as long as they don’t take cashout. A rate of 5% or better WILL stimulate homesales and thereby decrease foreclosures. The Fed has cut rates by 4.25% and mortgage rates are higher than before the first cut?? I also think that they should drop the rates to 4% for mortgages IF the borrower waives his mortgage interest tax deduction (just a thought).IF the Feds cut another $400B check, I will be sick to my stomach. People will buy ipods and a sweater…there is no spillover beneft to the economy.

    • Lein me some money   November 2, 2008 at 6:55 am

      How come the stinking banks, can borrow money at 1% and you say 5% is good for me? It is my stinking money that is being lent out!

  9. Anonymous   October 31, 2008 at 1:44 pm

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  10. Guest   October 31, 2008 at 8:02 pm

    If the government covers half of mortgage companies’ losses incurred in rewriting mortgages, as is being discussed, that could easily cost $40 billion to $500 billion.That’s a tremendous price to pay to reward the reckless and, indirectly, penalize the prudent. The benefit is obvious. Bailing out millions of individual property owners saves them much disruption and, ideally, serves to stabilize the housing market.But consider the lesson it imparts. City by city, neighborhood by neighborhood, people who live beneath their means and manage money carefully will see more careless neighbors supported by federal decree. Those who are current on mortgage payments, but still squeezed, may be tempted to let two or three payments slide, so they can negotiate money-saving terms on their own mortgages.We are becoming a nation of people who feel it is not only okay but justified to cheat, lie, and swindle each other and the rest of the population. Personal responsibility is discouraged by the govenment. White collar crimes are rarely prosecuted because FBI is so stretched. Our nation is eating ourself from within just to keep a facade of prosperity. Hope is being replaced by anger and desperation. Welcome to the new dawn.

  11. Anonymous   November 1, 2008 at 10:23 am

    you are absolutely right on with the above comment- I couldn’t agree more. I myself am highly responsible and definitely resent and disagree with rewarding those who have not been. That MUST NOT HAPPEN!!!!!!!

  12. economicminor   November 1, 2008 at 9:42 pm

    I have said this before on Professor Roubini’s blog.There are to many homes for the number of households. Many homes are no longer located where they are useful or functional as they are to far from the economic centers and to large to be maintained. The cost to build them exceeded their real economic value and all this will have to be written down to a much lower level. Add to this that wages have been declining or are stagnant in the face of rising prices in fuel, food, medicine, insurance and just about everything else. And on top of that the financial system enticed many people to indebt themselves beyond their ability to repay, even under a good economic environment, which we haven’t had. Many underwater homeowners are under water with not only the first on their homes but many have HELOCs and credit card debt and auto debts that are in the same underwater state.AND we are just entering into a period of increased resetting on Option ARMs.So, I just do not see how slowing down foreclosures does much except slowing down the entire re balancing. You might slow down the freight train that is running off the fallen bridge into the river but you can’t stop it.

  13. Guest   November 3, 2008 at 6:19 am

    If you want to stop foreclosures for people that can’t pay their mortgage, will you also stop evictions for those “under employed or unemployed” that cannot pay their rent? And if this program is for people with “no significant assets”, what on God’s earth would ever possess me to save even a nickle?