President Obama won't formally walk through the White House entry for a couple of months yet, but here's one crisis with a red-tag priority. If it could be attended to in the meantime, so much the better, because we won't begin to get out of our economic predicaments until a solution is found.
The issue is housing. It is where the current economic mess started, with the bursting of the home-price bubble followed by the financial industry's meltdown. The bad news is that the bubble has not finished bursting. Although homes, the major asset of the average American family, already have lost an average of 20 percent in value, most experts foresee another drop of at least 15 percent. Why? Because prices have not yet fallen to a level relative to personal income that can be sustained—at least not without the lax mortgage financing that produced the bubble in the first place.
In the decades since WWII, home prices as a multiple of annual rent have generally averaged 15 times. In the bubble, they reached a multiple of 26 and remain at 22. But as they fall, more and more homeowners will be saddled with mortgages that are worth more than their homes. If prices do drop an additional 15 percent, some 15 million mortgages will exceed the value of the homes. At least half of them would exceed the asset by 20 percent or more.
Borrowers can escape this negative equity by dropping the keys in the mailbox and walking away. Mortgages are "nonrecourse," meaning the lender has no other collateral than the property. But abandoned homes caused by such desertions, or homes left empty following foreclosure, are a plague on the neighborhood. Empty homes quickly fall into disrepair, attracting looters and squatters, and drag down the value of the entire street.
Such a vicious spiral of market deflation can produce an overshoot on the downside the same way that loosely inflated financing caused an overshoot on the upside.
Trillion-dollar losses. Most of the homes being abandoned and foreclosed will produce losses for the mortgage lender, which could add up to trillions of dollars and break the financial system before it is half repaired. If we don't get ahead of this destructive curve, the losses will swamp the bailout efforts of the government.
How can borrowers stay in their homes? Lenders would be better off forgiving part of the mortgage—but these days that route is too often closed off because most of the mortgages, especially the subprime and Alt-A mortgages, are securitized: They have been bundled into a pool with other mortgages that in turn have been sold to a diversified group of investors. Subprime loans packaged into securities skyrocketed from 32 percent in 1994 to 81 percent in 2006.
Initially, these securities helped expand the mortgage money available and reduce its cost. The problem is that the packaging process put the lender and the borrower a labyrinth of a distance away from each other, so the ability to renegotiate has become nearly impossible. Hence, foreclosures now exceed 2.5 million homes a year.
One remedy would be to give a legal right to change the terms of mortgage loans, or forgive part of them, to the servicers who collect payments on behalf of creditors. Yet another possibility is converting mortgages into longer-term loans with a lower fixed rate. Fannie Mae and Freddie Mac, the government-sponsored enterprises whose loose lending (prompted by Congress) helped get us into this mess, do have management skills that could help get us out. They could renegotiate any mortgage they own. They have the capacity to handle the necessary funding or guarantees from the government. Fannie and Freddie could tell banks they'd buy or guarantee any existing home mortgage at a fixed discount from the current principal, say 15 percent of the principal amount due. The understanding would be that the new mortgages would be supported by federal credit guarantees, with interest rates reduced to perhaps 5 percent and repayment schedules lengthened.
Martin Feldstein, a former presidential economic adviser, recommends that a part of this mortgage could be with full recourse to the mortgage borrowers in exchange for an even lower rate—he recommends $80,000 at 2 percent. The homeowner would have to assume personal liability for this extra piece of the financing—but once these mortgages become government-guaranteed, they would have clear value: They would become liquid and tradable and improve the liquidity of the entire financial system.