Friday, December 07, 2007

Squaring the Housing circle

TODAY, the Bush Administration released the details of its plan to offer assistance to struggling homeowners, and the blogosphere is busily chewing over the potential impacts. While markets appeared to cheer the plan (though perhaps more because it signals that federal action is in the offing than because of the great virtues of this specific plan), other pundits generally concluded that this is a limited--and first, one expects--step toward righting the housing ship.

The basics of the program are simple: homeowners with subprime, adjustable rate mortgages who cannot afford the interest-rate reset will have their loans frozen at the teaser rate for a period of five years.
There are many limitations, however.
Borrowers must have taken out their loan during a specific period, and the reset must be scheduled for 2008 or 2009--homeowners whose loans have already reset are out of luck. In addition, qualifying borrowers must not be able to refinance under the Federal Housing Administration's FHASecure plan, they must not have missed a payment, and their mortgage must not be greater than the value of the home. The last criterion has raised the ire of some liberal bloggers, who argue that the plan almost deliberately excludes low-income borrowers, although a more charitable explanation may be that such a restriction is necessary in order to prevent the most egregious abusers of the lending rules from benefitting.

The plan does receive measured praise, on the other hand, from some quarters, though most supporters append the proviso that more is needed. Of the criticisms, the most important is that this program will do very little to slow or halt the downward spiral in housing prices, which is itself a principle cause of increasing defaults. Dean Baker makes this point, as does the Economist, which writes:

Modifying a loan does not eliminate the risk of default later on, particularly when house prices are weak—and may become weaker still.
Since the Paulson plan includes only a subset of borrowers, it will have a modest effect on overall foreclosures, and on resulting downward pressure on prices. And weak prices mean higher defaults: a new paper by economists at the Federal Reserve Bank of Boston suggests that defaults by subprime borrowers are extremely sensitive to home prices, far more so than to other shocks, such as losing a job.
If prices continue to fall, in other words, loan modification simply puts off the inevitable.
As many observers have noted, prices are likely to overshoot in any downward correction as defaults and foreclosures flood the market with new supply while weakness in credit markets reduces the number of potential buyers. Many political leaders and pundits are calling for more action from the federal government, and many of those speaking out are recommending an extension of the rate freeze to other borrowers and for a longer period.
It's vital to consider the state of the housing market in addition to the mortgage market.
A combination of Larry Summers' proposal to maintain a steady flow of mortgage credit to qualifying borrowers with Dean Baker's rent-to-own policy--which would help keep borrowers in their homes and the homes off the market--might go a long way toward stopping the bleeding on home prices. Stem the price drops and the defaults will follow.
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