Fix Congress's Housing Fix

The once-in-a-century housing boom of the first half-dozen years of this decade has now turned into a bust. Home prices are down between 15 and 20 percent from their peak in 2006. Many experts predict as much as an additional 15 percent decline before the pricing bubble is undone.

Falling home prices have made it difficult for borrowers who have trouble meeting their mortgage payments to refinance or sell their home, leaving many with foreclosure as the only alternative. Some 10 million homeowners are haunted by the phantom of negative equity, whereby they owe more in mortgage than the value of their home. In part, this reflects mortgage loans that were made for virtually the total purchase price, when lenders and borrowers saw home prices soaring and did not worry about the burdens of meeting the schedule of repayments. They thought homes could be sold at any time, often at a hefty profit, a reasonable assumption since home prices had jumped an average of nearly 9 percent from 2000 to 2006, after rising an average of less than 3 percent in the 1990s. A typical home that was worth $150,000 in 2000 was worth $252,000 in 2006, instilling the optimistic view on the part of lenders, borrowers, and investors that credit risks could be washed away by rising equity.

Just as they acted rationally when they believed prices would always rise and they couldn't lose, they now see that prices are sinking fast while their mortgage debt isn't, and they don't believe prices will rebound anytime soon. No wonder they are prone to see that the most rational course is to mail in the keys, especially if they bought the property as a rental investment. The incentive to default is that mortgages are generally nonrecourse loans—i.e., creditors can take the home of someone not meeting the obligations but cannot seize other assets or wages. That has led to a new class of homeowners called "walkers," who have walked away from their mortgage debt.

Downward spiral. Mortgage delinquencies and mortgage foreclosures have risen from historically low levels at the end of 2006, picking up speed in nearly every quarter since then. According to the Census Bureau, over a million homes were in foreclosure at the end of the first quarter, and the portion of loans at least 30 days overdue climbed to a record 6.35 percent.

Foreclosures that began in the subprime mortgage area have now pulled more and more borrowers with higher incomes and good credit down in the undertow. Falling home prices have also made it more difficult for borrowers to tap their home equity loans, a form of second mortgage popular with homeowners looking for a cushion against future cash needs. These are now susceptible to elimination by the lenders on the grounds that declining home prices have reduced the home value ratio to unacceptable levels vis-à-vis the loan amounts.

The compounding loan defaults and the resulting foreclosures accelerate the downward spiral of home prices. It becomes a self-reinforcing process without any visible stopping point, given many sellers and few buyers. This comes at a time when the supply of new, unsold homes is at twice the typical level of a healthy market—an 11-month supply versus five to six months.

Hardly surprising, therefore, that housing is big news in both boardroom and bedroom. The housing bust represents the greatest strategic threat to the American economy, having already subtracted at least 1 percentage point from economic growth in the past quarter. It is the largest asset in the balance sheet of the average American family, and its decline in value has forced many to begin saving out of income instead of out of asset appreciation. This means consumer spending will be depressed at a time when higher gas and food prices are cutting deeply into purchasing power. Consumer confidence has fallen to a 16-year low. Foreclosures also have transformed tax-paying properties into tax-eating properties, creating a big problem for municipalities who not only lose the real estate tax revenues but also have to send in the police, fire department, and sanitation officials to prevent homes from being looted or vandalized, because empty houses attract squatters and drag down the value of entire neighborhoods. The result is that foreclosed properties often plummet in value.

How can we get ourselves out of this mess? Renegotiation of mortgages is one way. A million were renegotiated in the second half of last year. Why? Because a more realistic mortgage is better for everyone. Lowering interest rates, extending the term of the loan, or even forgiving part of the loan will stabilize the financials and keep the borrower in the house. Often, this preserves more for the lender than would foreclosure.

This was the wisdom expressed by Jimmy Stewart, playing the community-minded savings bank manager in the Frank Capra favorite It's a Wonderful Life. But the problem now is not just a tug of wills with a miserly local bank owner called Mr. Potter. In the new world of finance, mortgages were bundled into packages—securitized is the word—and so foreclosed homes, too, have been distributed to lenders and investors all around the world, making it difficult, if not impossible, to gain their consent for partial forgiveness. Servicers that collect mortgage payments on behalf of the investors and sensibly forgive part of a loan may be liable to a lawsuit from some creditor.

Everyone is trying to find a solution for the artificial downward pressure producing unnecessary foreclosures. Three ideas are working their way through the legislative chambers of Congress. One is to eliminate the tax liability associated with debt forgiveness on owner-occupied home loans. A second is to shorten the seasoning period that rehabilitated loans need to go through before they can be sold to entities like Fannie Mae and Freddie Mac. The third idea is for government to provide backing for 85 percent of the newly appraised value of the home, if the lender is willing to accept the loss between the previous mortgage amount and the new mortgage loan.

As always, the devil is in the details. By what standards are the appraisals to be made, and who makes them, given that residential appraisals have had a very dubious record over the past five years?

Favors for fat cats. There are other grave issues. The bill before Congress again reflects how good government intentions are perverted by interest group politics. It includes an obscene package of tax cuts, a blatant Washington handout to groups with powerful lobbyists, such as home builders. It would allow home builders, banks, and other firms taking a big financial hit to apply current losses to taxes they paid in past years—a retroactive tax benefit that would partially shield them, at taxpayer expense, from the full brunt of their massive business misjudgment in the past, when they earned dramatically higher profits on these practices and kept all the profits they made at that time.

The legislation also calls for $300 billion of troubled loans to be turned over to the Federal Housing Administration, which would expand the FHA portfolio to about 1.5 million mostly high-risk subprime mortgages. The Wall Street Journal hit the nail on the head: "At the very time private lenders and investors are fleeing subprime markets, Congress wants taxpayers to dive in." The Senate bill also would double the FHA's loan limits while lowering down payment requirements on mortgage acquisitions. All in all, this would make taxpayers responsible for tens of billions of dollars of additional mortgage losses.

The Journal, hardly an enemy of business, calls the provision to allow private banks to dump risky subprime loans on the FHA "the most reckless provision now on the Senate floor," and it points out that "lenders have all but admitted that, if the bailout becomes law, they will dump their worst loans on to the FHA." No wonder homeowners who didn't live beyond their means will ask why their taxes should help out the less provident—and the most reckless lenders.

Just as bad is raising the limits on mortgages to be guaranteed by the FHA or bought by Freddie Mac and Fannie Mae. These two quasi-public corporations were set up by the government to promote homeownership for moderate- and low-income families by providing a ready pool of mortgage funds. They are now involved in approximately 70 percent of all U.S. mortgages. But under the new bill, these two agencies would be able to buy and support mortgages to a level of as much as $630,000, reflecting home values of as much as $800,000. This assistance to the relatively well-off is hardly consistent with their mission. Fannie Mae and Freddie Mac, which are privately owned, are also dragging their feet in raising enough new equity because that would dilute their share values. This is intolerable. They already benefit financially from implicit government sponsorship, for their borrowing rates reflect the credit advantages of quasi-government support. They save literally tens of billions of dollars a year from reduced interest rates—a good portion of which is passed on to the companies' private shareholders.

It is not surprising that the White House threatens to veto the Senate version of the bill. The worm in the apple is manifest in the recent revelation of a whole group of Washington insiders who had preferential mortgage rates from one of the most egregious lenders, Countrywide Financial.

It is appropriate for the government to try to create a firewall around foreclosures because the country faces a real macroeconomic crisis in the danger of an accelerating, self-reinforcing collapse of home prices. Rep. Barney Frank put it well when he said, "The economy has been taken hostage by people that took some very bad decisions. The answer is to pay as little ransom as possible to the least ill-deserving people we can find." The legislation before the Congress, alas, benefits too many of the most ill-deserving people and companies. l

We didn't publish a magazine last week, but even belatedly we wanted to take note of the untimely death of NBC's Tim Russert. The loss to his family and friends, painful as it still must be, is equaled in significance by the loss to the media business that he loved. Each week Russert reminded us that good journalism is about doing your research and being tough but fair with the politicians and prominent people you cover. We share those values. His presence will be missed, but we hope his example will endure.