Troubled homeowners across the nation heaved a sigh of relief when Obama's Homeowner Affordability and Stability Plan was announced last month.
The $75 billion plan aims to keep about 5 million owners in their homes by modifying troubled loans. Not bad, right? As it stands, that plan may help some responsible but distressed homeowners avoid foreclosure. But the only way to reduce the bulk of foreclosures is by reducing the amount that borrowers owe lenders (principal reduction).
The good news is that principal reduction is not precluded in the Obama plan; it's just buried. Yet discussing this solution has been skirted in the debate: Why?
There are five roadblocks to implementing principal reductions. These impediments aren't as difficult to deal with as they might first appear to be. And once we remove them, we can make Obama's homeowner plan a home run:
1. Lenders don't want to recognize the loss, even though they know it's real.
This is irresponsible behavior and regulators should not permit it. A $250,000 mortgage on a $200,000 house is not worth $250,000. Not recognizing this leads to bad economic decisions and foreclosure. Foreclosure in this circumstance would yield a lender recovery estimated at $125,000. A much higher recovery could be obtained by recognizing the mortgage loss, and restructuring.
2. Loan servicers are afraid they would be sued for not recovering the full amount. This is a pathetic if somewhat understandable excuse for not doing the right thing. Thankfully, legislation has been proposed to come up with a safe harbor if a loan modification provides a higher recovery.
3. Servicers don't have the trained manpower to properly analyze each distressed homeowner's circumstance and develop an appropriate modification. This is a lame excuse for an industry that found plenty of trained personnel to devise and implement a rainbow of exotic mortgages. These same people could be retrained to fix the mess they helped create.
4. Responsible but nondistressed home-owners and taxpayers in general chafe at bailing out others. Responsible homeowners, renters, and taxpayers in general are being asked to bail out their less-responsible or less-fortunate neighbors. There is nothing wrong with bailing them out if the neighbors provide something in return.
5. Moral hazard. Homeowners benefit from a good economy with rising home values, but if things go bad they get bailed out. So what is there to keep them from buying the most expensive home and awaiting the outcome?
Those who benefit from a principal reduction should "pay" for it. Specifically, they should share a fraction of the future appreciation of their home with those providing the reduction. This avoids putting a cash burden on subsidized homeowners, which might compromise their ability to pay the restructured mortgages over the long term.
Appreciation sharing could be simply implemented by creating a standardized home-equity fractional interest security (or a HEFI, as my firm calls it). In return for reducing the amount a homeowner owes the lender, the homeowner would grant a HEFI to the lender. The HEFI might represent an appreciation sharing of 20 to 40 percent – depending on the amount of the reduction to the homeowner – when the home is sold. The HEFI value would be divided between the lender and the taxpayer in proportion to the subsidy provided by each.
For example, assume the current mortgage is $250,000 and the home value now is only $200,000 – the homeowner is "underwater." Further, assume the homeowner can only sustain a $160,000 mortgage (80 percent of the current home value). In this case, a new mortgage in that amount would be issued. It would conform to Fannie Mae and Freddie Mac criteria, so it could be sold by the lender at par to those entities.
In return for the mortgage write-down, the homeowner grants the lender a HEFI at 40 percent participation in the future home appreciation above the mortgage level of $160,000. Now the homeowner has an affordable mortgage, immediate equity, and 60 percent of any future home price appreciation (provisions that discourage immediate sale would be added).
Estimates done at University of California at Berkeley suggest that the present value of a HEFI in such a circumstance would be about 10 percent of the current home value, $20,000 in this example. Adding the conforming mortgage value of $160,000 to the HEFI value of $20,000 results in a lender/taxpayer expected recovery of 90 percent of the current home value. This contrasts with a lender recovery from foreclosure estimated at 62.5 percent of the home value.
Homeowners receiving principal reduction, and "paying" for it by sharing a fraction of the home's future price appreciation with the lender/taxpayer, is a win-win. It provides (1) a more secure homeowner, (2) a better lender/taxpayer recovery opportunity, (3) a greatly reduced moral hazard, and (4) a process that's fair to other home-owners, renters, and taxpayers.
It's a sensible and principled solution that's possible under the Obama plan.
John O'Brien is codirector of the Center for Innovative Financial Technology at University of California, Berkeley, and managing partner at Home Equity Securities LLC, which is working to establish a trading market for HEFIs.