Millions of people are underwater on their mortgages, and many of those borrowers have payments straining their ability to pay. The favorite solution of pandering lefties is to simply forgive the debt and lower the borrower’s payments. Of course, the solution would bankrupt the banks and cause significant future problems with moral hazard because borrowers would have a strong incentive to borrow imprudently in hopes of obtaining free money. Principal forgiveness is not the answer, and despite loanowner’s false hope, no significant principal forgiveness is forthcoming.
Excessive mortgage debt is a drain on our economy as too much money is diverted to debt service, but the real problems with loanowners is their immobility. Loanowners are trapped by debt in their homes unable to move to take a better job. This causes resale transaction volumes to suffer which in turn puts less money into the economy through agent commissions and new home sales. The economy struggles due to the existence of the excessive mortgage debt.
Back in April of 2007, I first proposed a workable solution to alleviate the debt problem in the post: How Homedebtors Could Avoid Foreclosure.
As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don’t pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.
Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let’s further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.
This would solve a multitude of problems: First, it would provide a mechanism whereby people who were victims of predatory lending could keep their homes. This would make the homedebtor happy, and it would get government regulators out of the bank’s business. Second, it would make the banks more money in the long run because they are still making their interest profit even if they don’t see it until the homedebtor sells the home (many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures would be the primary mechanism facilitating the crash, it would keep home prices from crashing by reducing the number of foreclosures.
Today I want to discuss a similar proposal that’s even more favorable to loanowners. Instead of converting the excessive debt to a zero-coupon second mortgage, make it a zero-interest second mortgage. Basically, you take the “forgiven” debt, freeze it so it doesn’t get larger, and hold it against the property to be recovered by future appreciation similar to the zero-coupon idea described above. Lenders won’t be quite as excited about the idea because they will not be earning interest on their money, but at this point, it’s better to get a return of their capital even if they must sacrifice a return on their capital. This solution also solves some of the other problems I noted with the zero-coupon solution.
The borrowers get to stay in their homes, but they still pay a price. They must give up the appreciation between today’s market value and their original loan balance. Borrowers are no worse off than they are today, and although most would be better off selling and buying a less expensive comparable property so they could keep the appreciation, most won’t do this. Most borrowers will stay in their homes even if they are basically paying an extra 30% to do so.
To really unfreeze the resale market, this zero-interest second must have automatic short sale approval written into the agreement. If the seller wants to get out before the house has appreciated to the point the zero-interest second is no longer underwater, the sale should require no further approval. This wouldn’t have worked years ago, but first mortgage holders are no longer holding up short sales anyway. The existing second mortgage holders are the ones causing problems with short sales today.
Compelling existing second mortgage holders to play along is more problematic. The second mortgages that are currently underwater and delinquent would be delighted to participate in the program. Right now, they have nothing, so if they have the chance to get paid back 10 years from now if the combined mortgage balance is no longer underwater, they are better off than they were today. The second mortgages that are not delinquent is a more difficult sell. As long as the borrowers are paying, second mortgage holders have no reason to participate. These second mortgage holders will benefit from the first mortgage converting part of their principal to a zero-interest loan because the borrower will have greater ability to pay on the still-current second.
Does this idea sound crazy? A senator from Oregon doesn’t think so.
Senator unveils plan to refi 8 million underwater borrowers
By Jon Prior — July 25, 2012 • 11:37am
Sen. Jeff Merkley, D-Ore., submitted a new plan Tuesday for the government to buy up to 8 million underwater mortgages and refinance them into lower rates.
“There is no robust program that enables large numbers of families trapped in high- interest loans across America to refinance,” Merkley writes in a paper detailing the plan. “The lack of such a program hurts our families, our communities, and our economy. That is unacceptable, especially because such a program is entirely feasible.”
The senators proposal would make millions more loans subject to government backing thereby exposing the taxpayer to significant risk of loss.
Merkley describes how a Rebuilding American Homeownership Trust could be built by either the Federal Housing Administration, the Federal Home Loan Banks system or the Federal Reserve. The RAH Trust would sell bonds and use the funds to purchase mortgages from banks, credit unions and originators.
If the federal reserve were to take these loans onto their books, they can always print the money to cover the losses.
Borrowers of these home loans would then be given three choices to refinance within three years.
A homeowner could choose a 4% fixed-interest 15-year mortgage. If the monthly payment were kept the same, the shorter term would allow the borrower to rebuild toward positive equity within three years.
Very few will do this, but it would be the best alternative for holders of the zero-coupon seconds. It isn’t just appreciation that builds equity. Declining loan balances do the same.
A standard 30-year fixed-rate mortgage could be provided as well with lower monthly payments.
Or the borrower could break the 30-year mortgage into a collateralized first mortgage for 95% of the property value and a mostly uncollateralized second mortgage for the balance of the loan.
This is the zero-interest solution I described above. Nearly everyone will chose this option because it has the lowest payment.
The RAH Trust could sell the first mortgage into the private market and structure the uncollateralized part into a “soft second.” No payments would be charged on the soft second and no interest will accrue for five years.
For as much as I don’t like loan modification programs, at least this one doesn’t forgive principal, and it has a chance to really work because the payments will be much more affordable. With the significant equity recapture, the banks get some of their money back, and the borrower has consequences for borrowing too much.
Merkley details how each of the three options would affect the balance over time (click the graph below to expand).
According to the plan, the RAH Trust would profit off the difference between the cost of funds on the bonds and the interest rates charged to borrowers.
There would be other rules put in place. No short sales will be considered in the first four years.
This would be necessary to prevent people from strategically short selling. I would drop this requirement to help increase worker mobility. I would allow the short sale, but ding the borrowers credit to provide some consequences.
Borrowers would pay mortgage insurance until they reach an 80% loan-to-value ratio.
Another proposal to get more money into the FHA insurance fund. This is also a good idea.
Eligible borrowers would have to be current on their mortgage. Many of the estimated 11 million underwater homeowners are.
This will piss off many people who were told to default to get a loan modification, but too bad.
Merkley said in the paper there could be other sources of revenue such as the Hardest Hit Fund or money unspent on underwhelming programs of the past.
The Federal Housing Finance Agency recently expanded the Home Affordable Refinance Program, which has swept hundreds of thousands of more Fannie Mae and Freddie Mac borrowers into lower-interest loans. But the boom could slow by September as lenders reach capacity.
Other programs such as HAMP, FHA Short Refi fell short of original estimates, and legislation to provide more refinancing opportunity for underwater borrowers remain stalled in Congress.
“This program is designed to break through many of the obstacles that have bedeviled earlier efforts to fix our housing market,” Merkley writes in the paper. “By utilizing competing lenders, the program would end the voluntary, sole-source system that has bogged down mortgage modifications.”
This idea may gain traction. It’s probably the least bad idea floated so far. All loan modification programs have some amount of moral hazard, and this one does as well; however, with consequences for participation, the moral hazard should be kept to a minimum. It’s certainly better than forgiving principal, and if politicians are intent on doing something, I would rather it be some form of zero-interest second with equity recapture.
The housing collapse was not kind to private-party second mortgages
The former owners of today’s featured property were Ponzis — who wasn’t — but part of their HELOC booty came from a $250,000 second mortgage from a private party. Perhaps this was a family friend, and they made some other arrangement for repayment. Whether they did or not, the lender is not going to get their money back from the property. It was foreclosed on by the first mortgage holder, and the guy with the second mortgage lost everything. $250,000 gone.
The owners bought this property back on 3/13/2003 for $520,000 using a $430,000 first mortgage and a $90,000 down payment. Their final refinance was for $620,000, so they pulled out at least $190,000. If the $250,000 private party loan was a cash payment, they made quite a profit before everything went south.
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Proprietary OC Housing News home purchase analysis
26036 MALAGA Ln Mission Viejo, CA 92692
$525,000 …….. Asking Price
$520,000 ………. Purchase Price
3/13/2003 ………. Purchase Date
$5,000 ………. Gross Gain (Loss)
($41,600) ………… Commissions and Costs at 8%
============================================
($36,600) ………. Net Gain (Loss)
============================================
1.0% ………. Gross Percent Change
-7.0% ………. Net Percent Change
0.1% ………… Annual Appreciation
Cost of Home Ownership
——————————————————————————
$525,000 …….. Asking Price
$105,000 ………… 20% Down Conventional
3.55% …………. Mortgage Interest Rate
30 ……………… Number of Years
$420,000 …….. Mortgage
$101,522 ………. Income Requirement
$1,898 ………… Monthly Mortgage Payment
$455 ………… Property Tax at 1.04%
$42 ………… Mello Roos & Special Taxes
$131 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$97 ………… Homeowners Association Fees
============================================
$2,623 ………. Monthly Cash Outlays
($297) ………. Tax Savings
($655) ………. Equity Hidden in Payment
$120 ………….. Lost Income to Down Payment
$86 ………….. Maintenance and Replacement Reserves
============================================
$1,876 ………. Monthly Cost of Ownership
Cash Acquisition Demands
——————————————————————————
$6,750 ………… Furnishing and Move In at 1% + $1,500
$6,750 ………… Closing Costs at 1% + $1,500
$4,200 ………… Interest Points
$105,000 ………… Down Payment
============================================
$122,700 ………. Total Cash Costs
$28,700 ………. Emergency Cash Reserves
============================================
$151,400 ………. Total Savings Needed
The property above is available for sale on the MLS.
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31 Responses to “Principal forgiveness with equity recapture: a workable solution for loanowners”
Sorry, the comment form is closed at this time.
You either default or devalue, that’s the only workable solution. Everything else is just noise.
I like the types of equity graph, who did that?
I created that one back in 2007 to explain the basics of house financing.
It’s a great chart!
DeMarco’s Opposition Stirs Up Principal Reduction Debate
In a long-running debate, Edward DeMarco, acting director of the Federal Housing Finance Agency, stated again this week that he does not support principal reductions and does not endorse their use at Fannie Mae and Freddie Mac.
After stating his position, he immediately faced criticism and opposition from a broad spectrum of individuals, especially throughout the government. However, DeMarco’s decision received a few words of praise as well.
Treasury Secretary Tim Geithner sent DeMarco a letter stating his concern at DeMarco’s “continued opposition to allowing Fannie Mae and Freddie Mac (GSEs) to use targeted principal reduction in their loan modification programs.”
Geithner’s letter stated bluntly, “I do not believe it is the best decision for the country.”
He pointed to the FHFA’s own analysis for evidence that principal reductions could save the GSEs as much as $3.6 billion and could save taxpayers up to $1 billion.
This evidence has led economist Paul Krugman criticize DeMarco’s aversion to the strategy, reducing DeMarco’s argument to “because he doesn’t feel like it.” Krugman also called into question whether DeMarco is fit for his role.
In a similarly candid statement Jared Bernstein, senior fellow at the Center on Budget and Policy Priorities, told Reuters, “in unusual times, like the aftermath of the worst housing bubble implosion in decades with 30+% price declines, guess what? Write downs happen.”
In DeMarco’s letter to congress stating his position on the matter, he expresses concern regarding the “long-term consequences for mortgage credit availability.”
“Forgiving debt owed pursuant to a lawful, valid contract risks creating a longer-term view by investors that the mortgage contract is less secure than ever before,” DeMarco stated. This uncertainty would lead to “higher mortgage rates, a constriction in mortgage credit lending or both,” he said.
David H. Stevens, president of the Mortgage Bankers Association released a statement Tuesday expressing the trade group’s stance on the issue. ““FHFA has made the determination that the long term national costs of a widespread principal reduction program are unlikely to outweigh what may be a short-term gain for a few select borrowers in certain states,” he said.
“We agree that principal forbearance can help borrowers realize a payment reduction in a similar way as principal reduction. It is critical to implement solutions that help the American homeowner without incurring the negative long-term impact of making credit less available and more expensive,” he continued.
Sen. Bachus (R-Alabama) released a statement supporting DeMarco’s unwavering stance. He went so far as to say DeMarco “deserves praise for standing up for the best interests of the American people.”
“Everyone knows a job is the best foreclosure mitigation plan,” Bachus stated.
“Instead of more failed government programs, the President should work with us on bipartisan solutions that help create jobs and heal the housing market,” he added.
Krugman needs a straight jacket. 5150 that menace to economy.
Krugman never saw a giveaway he didn’t like, no matter the cost to the taxpayer.
The housing ATM is still broken.
Report: 81 Percent of Q2 Refinances Maintained or Reduced Debt
Freddie Mac released the results of its second quarter refinance analysis Wednesday, revealing that homeowners who refinance continue to strengthen their housing situations.
Freddie Mac’s report showed that 81 percent of homeowners who refinanced their first-lien home mortgage either maintained the same loan amount or lowered their principal balance in the year’s second quarter. Of these borrowers, 59 percent maintained about the same loan amount (the highest share ever recorded), while 23 percent reduced their principal balance by paying-in additional money at the closing table.
The median interest rate reduction for a 30-year fixed-rate mortgage was about 1.5 percentage points, translating into interest rate savings of about 28 percent-the largest percent reduction recorded in the GSE’s 27 years of analysis.
The net dollars of home equity converted to cash as part of a refinance (adjusted for consumer-price inflation) also fell, dropping to its lowest level in 17 years. In the second quarter, an estimated $5 billion in net home equity was cashed out during the refinance of conventional prime-credit home mortgages, a large decrease from the peak volume of $84 billion during Q2 2006.
Freddie Mac VP and chief economist Frank Nothaft attributed the increased refinance volume to enhancements created in HARP 2.0.
“The enhancements to HARP announced in October, such as removing the maximum loan-to-value limit, resulted in additional refinance volume during the second quarter,” said Nothaft. “HARP loans were about one-third of Freddie Mac’s refinance fundings during the second quarter, the highest share since HARP’s inception.”
Property-value change and loan age varied between loans refinanced with HARP and other refinances. The median property value depreciation for HARP-refinanced loans during the second quarter was 34 percent, while the prior loan had a median age of about 5.5 years. Other loans refinanced during the same period had a median property-value decline of 2 percent over a median prior-loan age of about 4 years.
“…The borrowers get to stay in their homes, but they still pay a price. They must give up the appreciation between today’s market value and their original loan balance…”
To be the devil’s advocate, how would such an arrangement work in a long term flat or declining market?
In other words, if long term appreciation (say 10 years) is zero or negative, what would be the win for the lender?
The lender loses to the degree that prices don’t go back up to the peak, and that’s true whether or not any special arrangements are made. It’s one of the many reasons I now believe the federal reserve will keep interest rates low until most housing markets across the country are back at peak prices. It’s the only way they can prevent their member banks from taking huge write downs.
Taking a page from the bubble era playbook, I suppose the banks could securitize and sell off the notes.
Maybe that would be one way for the banks to minimize the hit to their
own balance sheets and pass the risk on to someone else (Hopefully
the private markets and not US taxpayers)!.
Heck, a whole new futures market could be created! <;}
The federal reserve does not control interest rates. The federal reserve can not “keep interest rates low” if interest rates rise. The federal reserve influences interest rates, but once it’s influence no longer influences, interest rates will rise and real estate in “real” dollars will continue to decline. “Prices” may rise, but in real terms prices will continue to decline. Less people will be able to afford homes even though the MSM and most of the blogosphere will say affordability is better.
You can only pretend to pay down debt with more debt for awhile. This was never a housing crisis. It was and is larger now a debt crisis.
If your cause and effect is true. It’s going crash home prices in Orange County as mortgage rates increase.
Getting the banks out of this bind with your bond issuance is as much moral hazard as is refinancing the debt for the mortgage holder. These loans need to fail and foreclosures to follow swiftly if the housing market is to recover. Rip the GD bandage off already!
I agree with you; however, the federal reserve and the government are determined to prevent the write downs we all know are necessary. A program like this one is the only realistic way for them to accomplish that goal.
No QE3 for now.
Fed says economy may need help, keeps policy on hold
(Reuters) – The Federal Reserve stopped short of offering new monetary stimulus on Wednesday even as it signaled more strongly that further bond buying could be in store to help a economic recovery that it said had lost momentum this year.
Fed officials described the economy as having “decelerated somewhat,” a change of tone from its previous assessment in June when it said the economy had been “expanding moderately.”
The Fed’s policymakers also reiterated their disappointment with the slow pace of progress in bringing down the nation’s 8.2 percent jobless rate.
The central bank dashed expectations among some investors by taking no new measures, sending U.S. stocks lower and the dollar higher against the euro and the yen.
“They clearly underscored the downside risks to the economy and made it very clear they would be as accommodative as needed,” said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.
Many economists thought the central bank might extend further into the future its guidance for low rates but the statement maintained its late-2014 language.
The Fed nevertheless showed it was prepared to do more to support an ailing economy.
“The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed,” the Fed said in its statement.
That was a slight shift from its June statement when the Fed said it was “prepared to take further action as appropriate.”
Richmond Fed President Jeffrey Lacker again dissented against the late-2014 timetable.
U.S. economic growth slowed to 1.5 percent in the second quarter as consumer spending faltered, and unemployment remains far too high for the comfort of a central bank that has a dual mandate to keep inflation low and employment high. Job growth slowed sharply in the second quarter to just 75,000 jobs per month from 226,000 in the first quarter.
A report on Wednesday showed U.S. companies added 163,000 jobs in July, more than expected. However, that survey, the ADP National Employment Report, does not carry as much weight as the government’s more comprehensive labor market report due on Friday, which includes both public and private sector employment.
Manufacturing data from the Institute for Supply Management pointed to a second month of contraction in the factory sector.
I just hope this delay doesn’t mean it will be bigger.
1) Financial markets are expecting a full-on QE3
2) At this stage of the devaluation game, another full-on QE will jeopardize further, the long standing US petro$ hegemony it earned post WW2. It will also reduce the value of various income streams for those who hold underlying assets. It will also reduce the value of pensions and other self-interests related to the powers-that-be. Plus, if bonds return 0%, the only way to earn a return is by currency appreciation.
Those hoping/praying for a full-on QE3 are going to be blowtorched. And, judging by both deteriorating credit and recent disfunction in equities markets, the ‘torching’ has already begun.
I think you’re right. Many financial markets were betting on QE3 to keep asset values inflated. I suspect many will start looking for the exits.
Speaking of exits, check out ‘insider’ sell vs buy action so far this week…
http://www.finviz.com/insidertrading.ashx?or=-10&tv=100000&tc=7&o=-transactionvalue
So, does a major a QE 3, QE4…lead to rapid inflation. 10% to 15%?
With regard to your question, I think Kyle Bass summed it up nicely….
”I see inflation in the things you need and deflation in the things you own”.
Lowest velocity of M2 money in 50 years….
http://research.stlouisfed.org/fred2/series/M2V/
“”I see inflation in the things you need and deflation in the things you own”.”
I think this is what will happen at first, then we will see everything go up as they keep the pedal to the metal.
These things take years to manifest. It is difficult to pin the inflation to a certain QE, when, how high, etc.
All you need to know is the ’08 banking crisis is now a sovereign debt crisis. Nothing has been solved, only delayed and exacerbated. Debt monetization, 0% fed funds rate, and ‘safe haven’ status of treasuries (does anyone with a functioning calculator still believe this?) has only given us more rope to hang ourselves. They will print because that is all they can do. They have no solution because they are the problem. Once interest rates rise, and rise they will, the USA ARM treasury bubble will pop and the dollar will get kneecapped (repatriated). I’m hedged. Good luck timing when to GTFO, better early than late!!
Why does anybody believe anything Bernanke or the Fed says? What are the European swaps if not more QE? What is paying interest on reserves if not QE? People need to stop getting their information on the Federal Reserves actions from the Federal Reserve.
“The Fact that our economical models at The Fed, the best in the world, have been wrong for fourteen straight quarters, does not mean they will not be right in the fifteenth quarter” – Alan Greenspan
“If the federal reserve were to take these loans onto their books, they can always print the money to cover the losses”
IrvineRenter, you recommend socializing the losses? Unbelievable. Are there no consequences to this recklessness?
Who do you think feels the most pain when this inflation causes rising prices? The poor feel it most. The savers suffer as well.
Your comments are further promoting ideas of central planning, chicanery, can-kicking, dollar debasement, falling standard of living.
Foreclosure and failure are the ONLY healthy solution. This is the ONLY cure.
I don’t like the socialization of losses. I don’t like any loan modification or bailout program, but if they are intent on doing something, the way I outline above is the least objectionable. I have long advocated a true free-market solution to this problem, but I see the government is simply not going to allow the market to function. I wish it weren’t so, but that is the world we live in.
This blog, and others like it, serve their greatest purpose by continuing to beat the drum of truth and proper solution, not conceding to ‘least objectionable’, IMO.
If citizens concede here and there, everyone loses because the ‘free giveaway’ is perpetually alluring. Small giveaway leads to big; one leads to many. If i’m wrong, then Krugman 2012, let’s blow this thing wide open=)
Principal forgiveness will not break the banks. The federal government or the federal reserve will reimburse the lenders.
Can I get a 20 year zero payment, non-recourse loan? I would like a 2 million dollar NPB house. And would you kindly roll the RE taxes and HOA payments into the loan. I promise to give let the bank have all the profit or loss from the house and loan. Just don’t bother me for 20 years of free housing.