What Should Be Done to Help Households Facing Foreclosure?

Douglas W. Elmendorf
Douglas W. Elmendorf Former Brookings Expert, Dean - Harvard Kennedy School

November 13, 2007

Foreclosure rates on mortgages are likely to rise substantially in the coming year, as interest-rate resets push up payments for many households, and tightening credit standards and sliding house prices prevent these households from refinancing their mortgages. What, if anything, should the government do to help these households?

Unfortunately, good information about the financial situations of the households involved and the features of their mortgage contracts is very difficult to obtain at this point. Such information is important for forming sensible public policy, and research on these issues should be a high priority. However, the urgency of the situation for many households suggests that policy actions cannot wait for the full results of that research. Based on the information available today, I conclude that the government should help households facing foreclosure, but that this help should be fairly narrowly targeted and should be funded primarily by the government rather than Fannie Mae, Freddie Mac, or mortgage lenders.

General Principles
One principle for government policy in this area, as in many others, is to balance the protection of vulnerable members of society with the need for people to bear responsibility for their decisions. In the current situation, some struggling borrowers are victims of predatory lending, and others entered into mortgage contracts they did not understand. Other borrowers knew what they were doing and deliberately took risks, but we should still be sympathetic (at least to low-income people) who would have their lives disrupted by losing their homes, giving up any equity in their houses, and damaging their credit histories.

That said, our economic system of letting people make their own decisions is sustainable only if people bear the consequences of those decisions. It is not fair for the government to help homeowners being foreclosed upon, while not helping people who kept renting rather than taking out mortgages beyond their reach or who are now making sacrifices and successfully meeting their mortgage payments. It is also unfair to help people who bought homes principally as investments, and some regional evidence suggests that this group owns a notable share of houses at risk of foreclosure. Moreover, helping people who took risks and lost can encourage excessive future risk-taking.

To achieve this balance, the government should encourage and subsidize mortgage refinancing for households who can stay in their homes with a modest amount of help. Although many of these people might not own homes today if risks had been recognized fully during the past few years, forcing them out now would be disruptive to their lives and their neighborhoods. Government policy can, and should, help to ease their transition to a world with appropriate recognition of risks. In addition, the tendency of financial markets to swing from excessive confidence to excessive fear suggests that the availability of subprime mortgage credit has fallen temporarily below its future long-run level. At the same time, helping people who could remain in their homes only with large subsidies is less feasible and would be unfair to people who had been more cautious earlier. It is worth noting that programs to help people avoid foreclosure would also help some people who could remain in their homes without assistance. Yet, many of these households will also be struggling with interest-rate resets, so helping them does not seem like misplaced effort.

A second principle for guiding government policy is to resist the temptation to finance help for struggling borrowers by imposing the burden on so-called “irresponsible” lenders. Some lenders made loans they knew were nonsensical, so it would be fair and would provide appropriate incentives for future lending to hold them responsible for the problems that result. Thus, lenders who broke laws or ignored rules should be punished in the usual way. However, many lenders made loans they believed to be risky but reasonable, and neither the regulators nor credit ratings agencies nor purchasers of subprime-mortgage-backed securities said the loans were not reasonable. It would be unfair and would skew the incentives for future lending to hold these lenders solely responsible for the current problems. In particular, punishing lenders for issuing mortgages that were acceptable at the time but look undesirable in hindsight would reduce the future supply of mortgage credit, especially to subprime borrowers.

A third principle is that government support for refinancing should operate principally through the Federal Housing Administration (FHA) rather than Fannie Mae or Freddie Mac. The FHA approach has several advantages: To start, the magnitude, duration, and targeting of subsidies would be chosen by the government explicitly rather than arising indirectly from Fannie’s and Freddie’s decision-making. In addition, the risk taken by the government could be estimated explicitly (and perhaps charged to borrowers) rather than arising indirectly from the government’s exposure to these institutions’ decisions about what activities to undertake and how much capital to hold. Moreover, the approach would not interfere with long-standing efforts to reform these institutions and their regulatory oversight, in order to reduce the benefit to private shareholders of the implicit government guarantee as well as the risk to financial stability posed by such large intermediaries.

Specific Actions
With these principles in mind, several specific actions make sense.

First, the government should foster and subsidize organizations that provide counseling to households facing mortgage payment difficulties. Many homeowners who lose their houses to foreclosure never contact a credit counselor or their mortgage servicer to discuss their options. Yet, such counseling, and the interaction with mortgage servicers that often results, appears to have a high success rate.

Second, the government should encourage lenders to renegotiate mortgages that would otherwise face foreclosure. Foreclosures are very costly to lenders, owing to both direct transactions costs and reduced sales prices of houses obtained through foreclosure proceedings (as documented several years ago by Anthony Pennington-Cross). With cost estimates in the tens of thousands of dollars, substantial reductions in amounts owed can be better for borrowers as well as lenders. Federal regulators have already urged this course on the institutions they supervise.

Such renegotiations are complicated, unfortunately, by the dispersion of ownership due to mortgage securitization. Convening all of the parties affected by such renegotiations is much more difficult than in the traditional circumstance of mortgages owned entirely by the local financial institutions that issued them. Recent developments have highlighted other destabilizing aspects of securitization as well: It creates principal-agent problems between mortgage issuers and the ultimate lenders; it creates more uncertainty about institutions’ creditworthiness because the distribution of risk-bearing may be obscured (especially in tumultuous periods); and it shifts risk-taking away from the institutions with greatest regulatory oversight. At the same time, we should not forget the substantial advantages of securitization: It allows loanable funds to shift easily among regions and countries; it distributes risk to lenders most willing to bear it, which reduces the price of risk; and it shifts risk out of the heart of the payments system. In any event, finding efficient ways to renegotiate securitized mortgages is an important challenge.

A third action the government should take is to relax the terms and extend the reach of FHA lending. President Bush proposed lowering down-payment requirements, raising loan limits from the current threshold of roughly $363,000, establishing risk-based premiums, and extending access to homeowners who have missed payments because of resets. The FHA estimated that, with these changes, it would help 300,000 households to refinance in the next fiscal year. Yet, Federal Reserve Chairman Ben Bernanke recently noted that more than 2 million subprime mortgages will undergo their first interest-rate reset between now and the end of next year, so the number of households needing help may be well above the 300,000 level. Expanding the FHA’s role further would be straightforward. With taxpayer funding, for example, the FHA could reduce, or eliminate, insurance premiums, or could provide a small subsidy to reduce the principal amount owed by homeowners.

Actions to Avoid
Several policy actions proposed by other commentators do not appear consistent with the principles outlined above.

One example is an imaginative and thought-provoking plan put forth by Dean Baker and Andrew Samwick. They proposed “granting current homeowners the right to stay in their homes as long as they like, simply by paying the fair-market rent” as set by an independent appraiser. However, forcing lenders to become landlords would represent a sharp change in property rights. This precedent would likely reduce the future supply of mortgage credit, especially to subprime borrowers. In addition, the new mortgage structure they advocate raises questions about rules for appropriate house maintenance and procedures for households that miss rent payments.

An even more ambitious scheme was advocated by Bill Gross, who manages the world’s largest bond fund at PIMCO. He called for a program “of Rooseveltian proportions” to help homeowners. Given the culpability of some households for their current predicaments, and the unfairness of helping risk-takers while not helping more cautious people, a subsidy program of this magnitude would not balance protection and responsibility.

Ed Glaeser made the case for transfers to people who lose their homes to foreclosure. He argued that such transfers should be limited to $5000 per household, paid partly by lenders in the case of non-standard mortgages, means-tested, dependent on honest reporting of income in the mortgage application process, and dependent on a house being in good condition. Imposing the burden on lenders is not consistent with the principles enunciated above. Whether these subsidies achieve the right balance of protection and responsibility depends, in my view, on how many households would still lose their homes even if we take the policy actions discussed above.

Many analysts and policymakers have proposed relaxing restrictions on Fannie Mae and Freddie Mac. One possibility is to raise the caps on the value of mortgage-backed securities that Fannie and Freddie can hold in their own portfolios. However, conforming mortgages are now available at lower rates than they were three months ago, so allowing Fannie and Freddie to hold more securities backed by these mortgages would accomplish little. A related possibility is to raise the portfolio caps and require that some of the additional capacity be filled by subprime mortgage-backed securities. Because this proposal essentially compensates Fannie and Freddie for holding subprime mortgages by letting them hold additional prime mortgages, it highlights the implicit subsidy received by these institutions. The hidden nature of the subsidy, and the fact that its magnitude cannot be readily ascertained, make this approach less desirable than explicitly supporting the subprime market through FHA-sponsored refinancing.

Yet another possibility regarding Fannie and Freddie is to raise the threshold for conforming mortgages from the current $417,000. This change would enhance mortgage supply in a segment of the market where rates have increased and underwriting standards have tightened. Moreover, defending the existing threshold is difficult: The threshold binds differentially in different parts of the country, and it is already high enough that Fannie’s and Freddie’s activities are not tightly targeted. Still, this approach would run counter to longstanding efforts to reform these institutions.

In addition to helping households who will face foreclosure in the coming year or so, the government also needs to consider possible changes in regulation of mortgage lending going forward. In a book published earlier this year, former Federal Reserve Governor Ned Gramlich documented both the contribution of subprime lending to rising homeownership during the past decade and the harm that some subprime loans have inflicted on households. Reducing this harm without unduly restricting access to credit is an important challenge for public policy.

References and Further Reading
Baker, Dean, and Andrew Samwick, “Save the Homeowners, not the Hedge Funds,” The Providence Journal, August 31, 2007.
Bernanke, Ben S., “The Economic Outlook,” November 8, 2007.
Glaeser, Edward L., “Sensible Solutions to the Lending Mess,” The Boston Globe, September 7, 2007.
Gramlich, Edward M., Subprime Mortgages: America’s Latest Boom and Bust, 2007.
Pennington-Cross, Anthony, “The Value of Foreclosed Property,” Federal Reserve Bank of St. Louis Working Paper 2004-022a, September 2004.