Mortgage Relief: A Better Approach

Back in February, the Obama Administration committed $75 billion to make mortgages more affordable to homeowners under financial pressure. Last week, however, the Congressional Oversight Panel for the financial bailout criticized the design of this mortgage modification program, and declared that “in the best case” it would prevent half as many foreclosures as the Administration predicted.

The Congressional Panel is right. The program does offer substantial financial incentives to banks and mortgage servicers to reduce homeowners’ repayments to 31% of their monthly income. But it provides little incentive for these firms to reduce the principal outstanding on a mortgage. In other words, lower monthly payments are achieved by lowering the interest rate and extending the term of the mortgage; the principal outstanding on the mortgage remains the same.

Of course, this does help reduce cash flow strains on struggling homeowners. But the evidence suggests that for “underwater” mortgages, where the outstanding principal on the mortgage is higher than the fair market value of the home, this kind of mortgage modification does little to reduce the likelihood that the homeowner will default.

In July of 2009, for example, analyst Mark Hanson published data showing redefault rates of 34% to 59% for homeowners within 10 months of a mortgage modification. His explanation: “Loan mods are designed to keep the unpaid principal balances of the lender’s loans intact while re-levering the borrower.” In other words, the program does little to make it difficult for homeowners to walk away from any mortgage at the next sign of trouble. With no equity in their property, what do they have to lose?

On that basis it would make much more sense for the Obama Administration to spend its $75 billion on reducing the principal on underwater mortgages of qualifying homeowners. That would give homeowners some skin in the game.

Here’s how such a program could work:

1. A federal agency would buy home mortgages at a price below the current principal from financial institutions. They should be willing to sell at 70% or 90% of the current principal in order to avoid much larger losses and legal costs on mortgage foreclosures.
2. The federal agency would then issue new mortgages to qualifying homeowners at 95% of the current fair market value of their homes. Since these homeowners would have equity in their homes, they would be unlikely to default on the new mortgages.
3. The mortgages would be repayable in 10 years with interest at 2% above the current rate on 10-year Treasury bonds — roughly 5.4% at today’s rate on 10-year Treasuries. The 2% difference between the federal agency’s funding costs and the interest rate on the mortgages would help finance the principal reduction program.

Would you support using the $75 billion for this kind a principal reduction program instead of the current mortgage modification program?

Bob Pozen is a senior lecturer at Harvard Business School and the author of the forthcoming Too Big to Save? How to Fix the US Financial System (November 2009)