Can the Housing Rescue Bill Really Work?

Not too long ago, I confess I was in a rather panicked state of mind about the economy. This was after Bear Stearns tanked but before IndyMac was seized by the FDIC. I thought that if the U.S. government could intervene in a big way and refinance homeowners who were facing foreclosure, then the free fall in housing values could be stopped and the economy could be stabilized.

Now that a housing rescue bill is about to be signed by the president, I’m not so sure.

The bill contains a variety of features, including incentives for first time home buyers and the now infamous Freddie and Fannie bailout. However, the part of the bill meant to help families facing foreclosure will only apply to a small portion of homeowners.

Certain requirements must be met in order for a borrower to be eligible for the program. First, the borrower must live in the home. Second, the mortgage has to be at least 31% of the borrower’s gross monthly income. Third, the borrower’s income must be verified even if the initial mortgage was a ’stated income’ mortgage that required no verification. Fourth, the mortgage company or bank that made the initial loan must agree to a refinance at no more that 90% of the home’s current value.

In other words, the bank holding the mortgage has to agree to take a loss or the whole deal is off.

We don’t really know if lenders will agree to this last requirement. A loss of 10% doesn’t sound that bad on the surface, but the terms are 90% of the home’s current value. In some parts of the U.S. where the housing bubble was especially out-of-control, home values have already dropped by as much as 30%, so if a buyer has a 100% “creative” sub-prime loan on a property like that, the lender will have to agree to a 40% loss. Thus far, lenders have not been anxious to rework loans or agree to short sales on homes facing foreclosure. It’s hard to know why they would be motivated to do so now.

Other terms are also problematic. If a borrower makes $32,000 a year, the mortgage payment on the soon-to-be-foreclosed property would have to be in excess of $826 a month in order for the borrower to qualify. That will cut out a lot of people in trouble on their loans. So will the income verification requirements. While it is certainly sound and sensible to require verification, chances are good that if the buyer couldn’t produce it for the original loan or couldn’t get a loan with proper income verification, that buyer won’t be able to get the refinance either.

Estimates on the total number of foreclosures expected within the coming year range from three to five million. Say the lower number is correct. That means the help this bill provides is a possibility for about 13% of the homeowners currently facing foreclosure. And of those 13%, only the ones who can get their original lender to accept a loss of anywhere from 10-40% will be successful.

That’s not very encouraging.

Before Bear Stearns failed, Benjamin Bernanke was asked about how to stabilize the housing market, and he made a suggestion that he said he knew would never be taken but he thought might work. His suggestion was that each original lenders rework the loans made during the housing bubble so that the loans were more in line with the property’s current actual value; that is, that each lender take a loss by reducing the principal on the loans. That would immediately make the loans good: the property value would match the loan against it. He knew however, that lending institutions would be loathe to do this.

Again and again we come back to this issue of lender responsibility. We all know that individual people can and do make terrible financial decisions. Faced with the prospect of rapidly inflating home values, lots of people jumped into loans that didn’t make sense on properties they really couldn’t afford, hoping it would all work out over the long haul as their homes grew more and more valuable.

Financial institutions however have a fiduciary responsibility to themselves and their customers to be smarter than that and to take the long view. We all know now that they did not do anything remotely close to that. In fact, not only were too many sub-prime “creative” loans made, they were then repackaged and sold as rock solid securities in ways that spread the contagion throughout the entire financial system.

Looking back, I think Bernanke had it right the first time: the correction should occur at the initial lending institution, and if it goes down as a result, so be it. That’s the market at work, right? Doing what it does best, killing off the weak and the poor decision makers. What we have now is the government stepping in to offer tepid help to a very few and attempting to back private bad debt with public bad debt.

The bailout portion of the bill is fodder for another post.

By even the most conservative reckoning, housing values still have a long way to fall before the market stabilizes. Many are putting that bottoming-out somewhere around 2010 or even beyond. In the worst case scenario, home values drop so precipitously that even “good” loans go upside down (that is, the borrowers suddenly owe more than the home is worth) and Fannie and Freddie have to actually start tapping Uncle Sam for cash to stay solvent.

If that happens, the terms of the rest of the bill won’t really matter anymore.

I think the bill can work if it isn’t used. That’s a weird place to be, and not a comfortable one.

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