State and Federal Policy in the Foreclosure Crisis

Alice Rivlin gave a luncheon speech at the State Summit on Foreclosures and Housing Solutions hosted by the National Governors Association. She touched on the root of both the credit and foreclosure crises but also provides reasons for optimism in the current situation.

First let me say a word about the economic context in which state and federal governments are likely to be dealing with the foreclosure problem, because the context matters a lot. If, as I expect, we are recovering from a slowdown or a mild recession in the overall economy by the end of this year or beginning of next, we will still have a serious foreclosure problem. We built too many houses. Prices rose faster than true supply and demand could sustain. It will take a while to absorb the excess housing stock, especially in some parts of the country. Housing prices will not recovery quickly and foreclosures will continue to mount, at least for a while. That will be a challenging, but manageable problem—confined to dealing with mortgages, foreclosures, and housing markets–not compounded by rising unemployment, falling consumer sales, commercial bankruptcies and other problems of serious recession. If, however, we have to deal with spreading foreclosures in the context of a general economic melt down, we will be in much deeper trouble, and foreclosures will be only a small part of general economic distress.

At the moment we can’t be sure, but there are signs that we have dodged the bigger bullet. Early last year, it was clear that the housing market had peaked and housing constructing was slowing dramatically. Foreclosures were rising and people were focusing on the fall-out from the sub-prime lending frenzy. But most economists did not see a massive problem. Housing construction is an important part of the local economy in many growing areas, but it is not a major national employer. And the subprime market, while worrisome, did not dominate the mortgage market. But last August the seriousness of the crisis became apparent as world credit markets came to a screeching halt. Belatedly market watchers realized that the housing boom and the lending frenzy had been fueled by the bundling of mortgages into mortgage backed securities marketed to investors around the world. Moreover, the apparent success of this market had spawned a lot of copy-cat transactions in assets backed by car loans and credit card debt and all sorts of other stuff.

Amazingly, the very smart people who buy and sell these securities had failed en masse to ask some pretty simple questions, like, ”What happens to the value of these securities when the price of houses in the United States stops rising and begins to go down?” Housing prices had been going up for so long that people had forgotten they could also go down. And guess what? It was happening.

There was real fear that wide-spread losses on mortgage backed securities would bring down major financial institutions and that credit would dry up and the rest of the economy would be severely affected. There was a lot of scary, apocalyptic talk about meltdown. Suddenly, the doomsayers dominated the airwaves. There was talk of deep recession and references to the 1930’s. Predictions of a spreading wave of foreclosures sometimes sounded like just about everyone was going to lose their homes. People made references to the end of the American Dream. Pessimists predicted the loss of America’s global leadership, a worthless dollar, and a massive loss of jobs. The foreclosure crisis was viewed as a symptom of the problems of a nation that has been living beyond its means, borrowing too much, saving too little, and not thinking about tomorrow. The list of our financial transgressions is indeed long—the subprime market was only part of it:

• Credit cards—for your six-year old and your dog.
• Mortgages for bigger and bigger houses—with no down payment
• Car notes on gas guzzling SUVs
• The federal government spending more than it was raising in revenue and passing the bill to future tax-payers, starting a war without paying for it, and ignoring the cost of promises made under entitlements.
• Financial institutions that were lax in their lending standards and careless about risk management
• Loan originators who had incentives to make loans at high rates and get borrowers to accept teaser rates that soon went up and made the loan unaffordable. They were making so much money doing this that they were not asking questions about whether the borrower could really repay. It wasn’t their risk, because the loan was quickly sold to someone else.
• Regulatory agencies—both federal and state–that failed to protect vulnerable borrows or enforce ordinary lending standards (like verifying income).
• Investment banks bundling mortgages and other assets into increasingly complex instruments that buyers often did not fully understand.
• Rating agencies with incentives to please their clients with over-generous ratings of securities.

This litany of sins was long and serious and led many to wonder if we were not finally seeing the chickens coming home to roost. We don’t know yet—disaster might still strike–but I incline to the view that we have had a wake-up call or a warning shot. The litany of our short-comings must not be forgotten. We have a lot of fixing to do. But if the economy holds up and begins to grow again in a few months, we will have time to deal with the foreclosure damage in an orderly way, tighten up the rules about lending and borrowing, and return to more responsible behavior while there is still time to avoid catastrophe.

There are substantial reasons for optimism:

• The foreclosure crisis has been described as a perfect storm, but it was a storm that hit a strong, resilient economy which has been performing remarkably well for the last dozen years and has a history of absorbing shocks without much long term damage. Productivity growth, job creation, entrepreneurship. Not all the news is good: strains of shifting from heavy industry to services, increasing inequality. But the adaptability and resilience of the economy in the face of shocks is pretty impressive (dot.com bust, stock market crash, corporate scandals, 9/11). Moreover, the banking sector went into the crisis in strong shape and most banks have handled the crisis well.
• Another reason for optimism at present is that national policy has responded rapidly and aggressively to reduce the chances of serious recession. The Federal Reserve cut interest rates quickly and continuously. Much more important it acted creatively to get liquidity into the banking system. It acted as lender of last resort, not just to the commercial banks, which was usual, but to investment banks as well. The Fed recognized that the whole financial structure—nationally and internationally–was intricately inter-related and that securities markets had become the dominant means of financing economic activity. Hence, just assuring the soundness of the commercial banking sector wasn’t enough. This realization means that we will have to drastically rethink bank regulation, but so be it. The most dramatic event was the rescue of Bear Stearns. Bad decisions and bad-timing had brought a major player to brink. Fed didn’t bail-out Bear or its stockholders; it bailed out the whole financial system—relatively cheaply, if it works—by facilitating the orderly sale of an institution so intertwined with rest that its failure could have pulled a lot of bigger financial institutions, here and elsewhere, with it. Bear wasn’t too big to fail, but it was too intertwined with the rest of the financial system. I think this rescue was prudent and necessary, but it put taxpayer money at risk and raised the moral hazard question squarely. If people are to be rescued from bad decisions, won’t they make them again? It’s a serious question. Policy has to strike a balance. There are moments when the risk of moral hazard is less than the more serious and immediate consequences of contagion. There are moments when containing fallout from bad decisions is more important than teaching the perpetrators a lesson. Bear was one. Spreading mortgage foreclosures are another. The other set of policy actors that functioned well were Congress and the Administration. A stimulus package put together swiftly by parties not used to working together smoothly. It should help ensure that the real economy holds up while we cope with the fallout from the housing bubble. So far, the real economy seems to be holding up reasonably well. The weak dollar is stimulating exports and slowing imports—the self-correcting mechanism seems finally to be working. If we are lucky we may get a chance to get our act together without going through a wrenching recession. We need to do two things at once: contain the damage and prevent a repetition. The latter is easier, but we will have to be careful not to over-react. It would be easy to over-restrain housing finance, in the name of ensuring that all the prior abuses were corrected.
• We should remember that the long, sustained housing boom created a lot of good housing. Housing construction got out of hand in the end—as good things often do. It will take a while to absorb the extra housing units and prices will probably keep falling for a while. But Americans are a better- housed nation than we were a few years ago, and lots of families have moved up into better homes, as well as improving the homes they had..
• Subprime mortgages have a bad name at the moment—associated with predatory practices, fraud, greedy lenders and incautious borrowers, and now with defaults. But sub-prime lending was not a bad idea. It created a way for people with less than perfect credit to buy a home and establish their credit. Millions of families benefited and most of them are not in default. They are living in those houses and making their payments. Defaults on sub-prime loans are high by comparison to prime loans, but they are far from a majority.
• Mortgage backed securities also have a bad name, but they were definitely a positive innovation. Securitizing mortgages has pooled the risks that used to be borne by local lenders and attracted a lot more capital into the housing market. Americans would not be nearly as well housed as we currently are without MBS—we just have to learn to manage their consequences better. This is the first time we have had a decline in housing prices and a substantial rise in foreclosures in a world of securitization. So we have to figure out how to minimize foreclosures and encourage renegotiation of mortgages in this new world. In the old days small town bankers were substantial citizens of their towns and had a stake in the viability of their neighborhoods. Even big money center banks had strong incentives to minimize foreclosures. But those days are gone forever. When a foreclosure crisis hits now, exhorting lenders to renegotiate with borrowers does very little good. There are no mortgage lenders. There are only originators, who no longer have a current stake in the loan, servicers with ambiguous legal obligations to investors, and investors with diverse interests, because they own different tranches of a mortgage pool with different risks attached. Servicers had no experience with minimizing foreclosures. Their job was to process the mortgage payment—not renegotiate the loan. So everybody is trying to figure it out.
• My final positive point is that falling housing prices are disappointing, even catastrophic for owners and sellers. But they open opportunities for buyers. Millions of families will be able to afford a first home or a better home (if they can get financing) that might have been beyond their means if the boom had continued. Cities that have seen not only low- but middle income people squeezed out of the housing market will see the prices ease. They may even see some city workers able to live in the city again. Community land trusts may be able to add significantly to the supply of affordable housing in many areas where the supply of affordable housing has been dwindling.

So what should we do? One answer is: nothing—let the markets work. If borrowers made bad decisions and got in over their heads, why should tax payers help them out? Lot’s of people stayed in rental housing or smaller, older houses, because they were prudent enough not to take on more debt than they could handle. Why should they pay taxes to help the profligate? There are basically two answers. One is that part of the problem was public failure to protect the vulnerable and prevent unscrupulous lending. If public policy failed, it should help reduce the damage. The other argument for public intervention in the foreclosure crisis is containment—stopping the spreading contagion of foreclosures that will devastate neighborhoods. The balance problem is similar to the issues in Bear Stearns. Foreclosures affect property values in the neighborhood, including those of the prudent, and can drag a whole neighborhood into spreading foreclosures. So there is a strong case for major efforts to keep families in their homes if they have reasonable prospects of being able to meet the payments on a renegotiated loan that reflects the lower value of their house. There is less justification for delaying foreclosures on people who are not likely to ever to be able to make the payments.

The big questions are: should the government put taxpayer money at risk? If so should it create a new agency or work through existing ones? And more importantly what should the government try to do? Should buy pools of mortgages directly? This would help holders of these securities unload them at a loss and write them off. The federal buyer could then work with the home-owners to prevent foreclosures. Or should it get money to state and local agencies to enable them to buy foreclosed properties and/or work to prevent foreclosures?

So far the Administration has been opposed to putting taxpayer money at risk to contain foreclosures in any of these ways. The Treasury has encouraged voluntary renegotiation and counseling. Some federal funds have been appropriated for counseling. Treasury has worked with a group of servicers in Hope Now program to encourage extensions of teaser rates. FHA Secure which has also helped some borrowers in trouble because of ARM resets that were otherwise able to pay. The stimulus bill also gave Fannie and Freddie more leeway to buy larger loans, which should help some renegotiation, and raised limits for FHA guarantees. These are all helpful moves, but not likely to produce large impact.

Congress has talked about moving more aggressively, and has worked hard on legislation, but has not yet come to an agreement between the House and the Senate that the President will sign. Chairman Barney Frank’s bill passed the House early this month is the most promising. The American Housing Rescue and Foreclosure Prevention Act puts the FHA squarely in the business of guaranteeing renegotiated loans and expands their authority. The borrower and the lender must work out the terms with each bearing some of the loss and the FHA shares in any future resale in return for the guarantee. Other parts of the bill give tax credits to first time home buyers to encourage their getting into the housing market now that prices are more affordable.

Other bills designed to channel resources to states and communities and community groups for expanding affordable housing options through community land trusts and other mechanisms.

Chances of compromise with the more conservative Senate and Administration agreement are not clear. States may be left on their own until after the election or longer. Since, the impact of foreclosures on states is so variable, as are state economic conditions, very different responses are appropriate and feasible. It is a moment when state creativity could come up with some innovative and place appropriate solutions. That is big advantage of federal system—even in a crisis.