Posted by: adoseofliberty | December 10, 2009

To Default, or Not To Default

The New American Dream

At the root of the financial meltdown last year was the decline in home prices, not only in isolated neighborhoods or cities, but the country as a whole.  Still surprising however is the sharp decline in home-ownership rates in the United States, with the current level at 67.8%, down from a peak of 69.2% in 2004, the largest drop since the late 1980s.

Mark Whitehouse writes in the Wall Street Journal about the home ownership situation and upcoming wave of defaults in a piece aptly titled “American Dream 2: Default, Then Rent“:

And more renters are on the way: Credit firm Experian and consulting firm Oliver Wyman forecast that “strategic defaults” by homeowners who can afford to pay are likely to exceed one million in 2009, more than four times 2007’s level.

According to the same newspaper quoted in a good summary of the phenomenon at Calculated Risk, a startling 17% of home-owners would walk away from their mortgage if their negative equity (the amount they owe more than than the house is worth) reaches 50% of the house’s value.  This “strategic default” is dubbed as such when the homeowner is still able to make their mortgage payments, but chooses not to.

As Whitehouse points out, this is not only bad for the borrowers’ credit, it is damaging to banks and indirectly, the American taxpayer, since billions of dollars of taxpayer money were used to bailout banks last year.  And yet, with dizzying amounts of bailout money already anticipated as losses (see an earlier post), the Treasury is extending the TARP program until October 2010.  The default numbers start adding up in frightening ways:

Analysts at Deutsche Bank Securities expect 21 million U.S. households to end up owing more on their mortgages than their homes are worth by the end of 2010. If one in five of those households defaults, the losses to banks and investors could exceed $400 billion. As a proportion of the economy, that’s roughly equivalent to the losses suffered in the savings-and-loan debacle of the late 1980s and early 1990s.

“Stealth Stimulus”

The one “positive” aspect, also ironic and disturbing as explained shortly, is that this release of debt is providing consumers with more spending cash, one of the main components necessary to revive the economy.  Whitehouse explains:

For the 4.8 million U.S. households that data provider LPS Applied Analytics estimates haven’t paid their mortgages in at least three months, the added cash flow could amount to about $5 billion a month — an injection that in the long term could be worth more than the tax breaks in the Obama administration’s economic-stimulus package.

This “stealth stimulus” might actually have more economy-boosting power than tax breaks, one of the most direct methods of government stimulus.  Which sounds all the more absurd given the fact that President Obama and House Speaker Nancy Pelosi are thinking about a third round of stimulus spending, with more “shovel-ready” infrastructure projects, entitlement transfer payments and more funding for our bottom-of-the-world-class schools.  Granted, there were several ideas regarding tax incentives for small business, the key to economic recovery, but these always seem to end up being canned in the final act.

Curtailing the Defaults

As to the question of how to prevent these defaults, the Los Angeles Times’ Tom Petruno earlier in June offered an alluring solution for mortgage-holders warmly referred to as a “homeowner principal forgiveness vesting plan”:

Say an owner’s mortgage is worth $400,000 but his house is valued at $300,000. The government would refinance the $400,000 loan with two new loans. Fannie Mae, the mortgage financier now under government control, would provide a first loan for the market value of the house, in this case $300,000. The Treasury would issue the second loan, in this case for $100,000.

The Treasury loan would be interest-only and would provide the vesting part of the program. For each year that the homeowner keeps up payments on both loans, one-fifth of the Treasury loan would be forgiven.

That is just great.  For the home-owner at least.  Not so much for the those of us who pay taxes, the true “forgivers”, albeit involuntary ones.  Not to mention the introduction of yet additional moral hazard, as if we haven’t had enough the past year and a half.

So here are a few ideas that would be difficult to swallow at first, but don’t end with the well-known chorus line of “Rest in Peace, O Ye Taxpayer”:

  1. According to Whitehouse, “California is one of 10 states that largely prevent mortgage lenders from going after the other assets of borrowers who default.”  Eliminate this crippling rule and make borrowers face the consequences of their own risk-taking.  As mentioned above, there’s a whole list of people down the line who get screwed when an borrower defaults.
  2. Stop artificially inflating home prices by implementing policies to fulfill the political goal of “increasing American home-ownership.”  Let the market be the guide for people when deciding whether or not they want to buy or rent.  This means scrapping programs like Fannie Mae’s Community Home Buyer’s Program that “builds flexibility” for lenders’ requirements, eliminating FHA loans, and repealing mandates that force developers to allocate parts of projects as “affordable housing units”, as is an ongoing issue in New Jersey.
  3. End the era of bailouts.  Banks and investment firms will pay much closer attention to the assets behind their financial instruments if they have no guarantee that Uncle Sam will always be there with open arms.
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