Best housing 'bailout' may be no bailout
Plans that systematically reduce mortgage costs could make matters worse and slow the recovery process that's already in motion.
NEW YORK (Fortune) -- Several mortgage-rescue plans are making the rounds in Washington, but economists say the best approach may be to sit tight.
Those who favor bailouts for strapped borrowers say government intervention is needed to stop a vicious cycle in which foreclosed homes get dumped on the market, driving down home prices further and leading to more foreclosures.
But prices show little sign of the disastrous collapse that the bailout advocates want to prevent - though the declines of the past year seem scary, they are very much in line with what would be expected by the fundamentals.
In fact, the market is already doing its job by making home prices affordable for the first time in at least a decade. We need to let those forces keep working.
"The last thing we want to do is manipulate home prices," said Paul Willen, an economist at the Federal Reserve Bank of Boston, and co-author of a recent study showing that foreclosures are following an historical pattern, not causing an unprecedented death spiral. "They need to find a level where homes become affordable, and buyers return."
The bailouts would simply make the inevitable adjustment far more costly both to banks and taxpayers by encouraging homeowners to apply en masse for aid they don't really need.
Indeed, the plans themselves would encourage far more delinquencies and writedowns than if we simply allow prices to adjust to economic gravity.
It's a good idea to keep people in their houses whenever possible. That's because foreclosures are extremely costly in everything from legal fees to damage to homes.
But the plans would do little to prevent foreclosures that are in the cards anyway. And they'd layer on costs we'd avoid by simply letting foreclosures and the market do their job.
Let's look at the two leading bailout plans.
The first plan is the Help for Homeowners program, launced on Oct. 1. Banks can write down their underwater loans so that homeowners have positive equity, and take a big upfront loss in the process. In exchange, the banks then transfer the new loan, with the lower balance, to the Federal Housing Administration (FHA).
The second plan is the one unveiled last week by Sheila Bair, chief of the FDIC. It focuses on reducing the mortgage payment rather than the principal. The banks can choose to reduce interest payments to make the mortgages affordable - say from 8% to 4%. In exchange, the FDIC would guarantee up to 50% of the loss on the mortgage if the homeowner ultimately defaulted.
Both plans are voluntary: The banks have the option of using or ignoring them.
And they share the same basic problem - moral hazard. That is, they're both likely to attract a flood of applicants who would otherwise eventually pay the full principal amount (Hope for Homeowners) or make the full mortgage payment (the Bair plan).
In fact, the banks are now shunning Home for Homeowners for precisely that reason.
With the Bair plan, banks fear that it would encourage millions of homeowners who aren't at the breaking point to claim they can't pay their mortgages. The banks, meanwhile, would take a big charge for the lost interest, which would exceed the cost of foreclosures they'd face without the plan. The modest loss-sharing subsidies they'd get on future foreclosures wouldn't come close to making up the difference.
"The problem with a bailout is that it's attractive to everyone, including the people who would otherwise pay," said Willen. "The bailouts put people in a position where it's in their interests to understate their incomes or stop making payments in order to qualify for aid."
The fretting over foreclosures is largely driven by a widespread misconception - that the large number of Americans "underwater" on their mortgages with default en masse.
Why, the worry goes, would a homeowner remain in a home worth $250,000 with a $300,000 loan when they could "walk away," then buy a new house for $50,000 less than they owe?
That fear, however, is greatly exaggerated.
In a study of the weak Massachusetts housing market in the early 1990s, Willen and his co-authors found that 100,000 homeowners were underwater, but that ultimately just 6,500 - or fewer than 7% - lost their homes to foreclosure.
Homeowners try to avoid walking away, say the co-authors, because they know their credit would be ruined for years and because many figure home prices will eventually rebound, even if it may take years.
The ones who do default are almost always a relatively small group that suffers a damaging "life event," such as divorce, unemployment or a serious illness.
But today's crash is substantially different from the one in the early 1990s because of the rise of the subprime mortgage, a product that was virtually non-existent 20 years ago. The subprime borrowers who flooded the market from 2004 to 2006 are far more vulnerable to these "life events."
As a result, Willen expects a higher foreclosure rate this time around and thinks 15% of all borrowers with negative equity could lose their homes.
That's no small number: By the end of the year, Moody's Economy.com reckons that around 13.4 million homeowners will be underwater, so it's reasonable to project that over 2 million will lose their homes, in addition to the 2 million the banks have already sold.
While we shouldn't take that lightly, a lot of the damage has already been done, and if the goal is a recovery in real estate markets, bailouts aren't the answer.
Bailout or no bailout, it's impossible to prevent housing values from reaching a level where the cost carrying a home - chiefly mortgage and tax payments - is roughly similar to the price of renting a similar abode.
In the long run, rents exercise a kind of gravitational pull on home prices.
But during the bubble, prices became wildly untethered from the basic force that drives them. In early 2007, it cost two to three times as much to own than to rent in markets such as Sacramento, Orange County, Phoenix and Miami.
The solution to the housing crisis isn't a bailout, it's allowing the prices to fall so that they are back in line with rents - at which point new buyers rush in, inventories shrink and new homes start sprouting in stricken markets like Phoenix and Las Vegas.
The market already is doing its job brutally and efficiently.
With declines of 30% or more California markets like Sacramento and San Bernadino, home prices and rents in those areas are approaching equilibrium, according to Deutsche Bank Securities analyst Lou Taylor, who compiles a valuable quarterly survey housing costs in 55 urban markets.
As home prices continue to fall, Taylor predicts that dozens of grim markets could reach equilibrium by year end.
"We're getting back the affordability levels of 1999, before the bubble began," says Taylor.
In fact, from Phoenix to Los Angeles, falling prices are doing just what they're supposed to do, lifting sales and moving inventory.
In September, home sales increased 97% in California, surpassing 500,000 units for the first time in more than two years. The unsold stock of existing homes dropped from 16 months to 6.5 months.
According to RealtyTrac, banks now have 1 million homes for sale; that's around one-fifth of the total.
That's a lot, but while the while the total number of foreclosed homes the banks are selling is still rising, it's not at an alarming rate because falling prices are attracting buyers.
"Looking at the realtor data, we're seeing skyrocketing sales of foreclosures. Investors are buying up the homes. The key is that they can now rent them and break even while waiting for prices to rebound," says Taylor.
Any effort to push up prices before they reach the correct levels versus rents is major mistake. It simply discourages buyers.
Meanwhile, private banks will naturally work to keep those who can be saved in their homes.
JP Morgan Chase, Citigroup and Bank of America are all helping strapped homeowners to make their payments. But unlike the government plans, they're mainly helping people who have an excellent chance of staying in their homes, those who've lost their jobs but have excellent prospects for a new one, for example.
The banks want to avoid writing down the loans. Instead, they offer to forgo interest for a few months, but add the unpaid portion back to principal.
"That avoids the moral hazard problem because it simply changes the timing, not the amount owed," said Willen. "So it only attracts people who really need help, and really want to stay in their homes."