One Million Homes Lost and Counting: How to End the Foreclosure Crisis Now

Over one million U.S. homeowners have already lost their homes due to foreclosures since the mortgage crisis began last summer. Another one million homeowners are 90 days past due on their mortgages (foreclosure notices usually go out after 90 days) and two million more are 30 days past due, so three million more households may face foreclosure in the months ahead. If current policies do not change, it is estimated that up to five million homeowners would lose their homes due to foreclosure over the next few years. Five million is roughly 10% of the total number of homes with mortgages. This is clearly the worst housing crisis since the Great Depression, and will wreck havoc in the lives of millions of families unless something is done. A high foreclosure rate also has a deteriorating effect on surrounding neighborhoods, further depressing housing prices and quality of life.

Many of those facing foreclosure are low- to middle-income homeowners who were enticed into buying houses by fraudulent mortgage companies and low "teaser" interest rates that are adjusted up ("reset") after two to three years. As long as housing prices were increasing, homeowners could always refinance their mortgages and get a new teaser rate for another few years. However, now that house prices are falling, these homeowners can no longer refinance, and many of them cannot afford to pay the higher interest rates when they are reset. Falling prices also mean that many of these homeowners owe more on their mortgage than the current value of their house (i.e. they have "negative equity" in their house). The recession is also resulting in declining employment and income, meaning even more homeowners are struggling to make their monthly mortgage payments. The further housing prices decline, and the worse the recession is, the worse the foreclosures will be, in a vicious cycle.

Clearly, the federal government must take some positive actions to stop the spreading foreclosures, especially for low- and middle-income families, who would suffer the most. But what should those actions be? At a minimum, policies should apply only to owner-occupied homes, and not to "investor" or "speculative" homeowners (those who buy houses in order to sell them later at a higher price). But beyond this, various policies have been proposed, and not all of them would truly help homeowners at risk.

Workouts, Not Bailouts

There are two main types of anti-foreclosure policies: bailouts and workouts. In bailouts, the government gives aid either to lenders (e.g. by purchasing bad mortgages at their full original value) or to homeowners (e.g. by giving them loans so they can repay their lenders). Of course, aid to homeowners indirectly bails out the lenders as well. In workouts, the terms of the original mortgage contract are modified, either by reducing the rate of interest or reducing the principal owed, or both, in order to make the loan more affordable. So far, most of the proposals to deal with the foreclosure crisis have been more workouts than bailouts, although there are elements of bailout in some of them as well. The lenders made fortunes on these risky mortgages during the housing bubble, so if someone has to suffer losses now, it should be the lenders. There should be no bailouts of the lenders in any way.

Lender-Initiated Workouts

There are two types of workouts, depending on whether they are initiated by the lenders or the homeowners. Most of the policies proposed and enacted so far have been initiated by the lenders, i.e., they are voluntary on the part of the lenders. The main policy of the Bush administration is called "Hope Now," in which the lenders voluntarily postpone the resets of interest rates that are scheduled to take place in the months ahead, and leave the principal of the loan unchanged (or sometimes the foregone interest is added to the principal). The Bush administration claims that over 500,000 mortgages have been modified in this way in recent months, and estimates that another 500,000 mortgages will be modified in the months ahead. However, critics argue that these numbers are exaggerated and that many of these modifications have been simply allowing homeowners more time to make the same payments. It is likely that in the months ahead, many of these homeowners still will not be able to make their payments, and many of them will be foreclosed on, which has led some critics to call this the "No Hope" plan. The only lasting solution is to reduce the mortgage principal owed to more affordable levels. The main problem now is not the reset of interest rates, but rather declining housing prices, which has the effect that more and more homeowners now owe more money on their mortgage than their house is worth.

The House of Representatives has recently passed a bill (H.R. 5830, introduced by Rep. Barney Frank, D-Mass.) that is primarily a workout, but also is potentially part bailout, and is also lender-initiated The bill would replace existing mortgages with new mortgages that would have a value of 85% of the current market value of the houses, and these refinanced mortgages would be guaranteed by the Federal Housing Administration (how this "current market value" is to be determined is a crucial detail which so far has not been specified). This 15% "write-down" of the principal, plus the prior 10% decline of prices means that the total write-down for lenders will be approximately 25%. For example, a homeowner with an original mortgage of $300,000 would have the principal reduced to $225,000, and the monthly payments reduced by a similar proportion. The bill appropriates $300 billion for this purpose, which it estimates could help up to 1.5 million homeowners. A similar bill appears likely to pass in the Senate (introduced by Christopher Dodd, D-Conn.). President Bush initially threatened a veto, but has now said he will sign the bill. In any case, it does not appear likely that many lenders will "volunteer" for this writedown.

Another problem with this bill is that housing prices in some areas are likely to fall more than an additional 15%. Mortgages on these houses are likely to be the ones that the lenders will voluntarily refinance, and any further losses would have be borne by the government (i.e., by the taxpayers). This would be a partial bailout of the lenders.

Homeowner-Initiated Workouts

Another bill has been introduced into the House (H.R. 3609) and Senate (S. 26360) that would provide workouts that would be initiated by the homeowners and would be mandatory for the lenders. These bills would allow bankruptcy judges to modify mortgage contracts (by reducing the principal and/or by reducing the interest rate) in order to make monthly payments more affordable for homeowners. It used to be possible for bankruptcy judges to modify mortgage contracts, but this was explicitly prohibited in a 1993 bankruptcy law. One can see the hand of the mortgage bankers in the writing of that provision. Modifications on other types of loans are allowed: for investment properties, for vacation homes, and even for boats, but no modifications allowed for primary residences! So all that needs to be done is to delete this one phrase in the law which prohibits modifications for primary residences. A significant advantage of this plan is that it would not cost taxpayers anything.

One problem with this bill is that homeowners would have to declare bankruptcy, which is expensive (about $2000) and would hurt their credit rating in the future. But at least they would still have their home, with an affordable mortgage, and thus would have the chance to restore their credit rating.

This bill is supported by the AFL-CIO, SEIU, NAACP, ACORN, the Center for Responsible Lending, and many other consumer protection groups. It is of course strongly opposed by the Mortgage Bankers Association, and does not seem to have enough support for passage at the present time.

Another homeowner-initiated plan has been proposed by Dean Baker of the Center for Economic and Policy Research. According to this "own-to-rent" plan, homeowners faced with foreclosure would have the option to stay in their houses as tenants, rather than as owners, and would pay the prevailing rental rates, which are generally much lower than mortgage payments. Eligibility for the plan would be capped at the median house price in a metropolitan area and thus would not benefit high-income homeowners. This plan also would not cost taxpayers anything. A bill along these lines was recently introduced in the House (H.R. 6116).

Looking Ahead

The presidential candidates have had disappointingly little to say about the foreclosure crisis and anti-foreclosure policies. Senator Barack Obama has expressed support for the Frank-Dodd FHA bill, but not yet for the bankruptcy modification bill. In good Republican tradition, McCain advocates "no government intervention." But the foreclosure crisis is likely to worsen in the coming months, and the public may well demand more policies to address this growing problem. The homeowner-initiated policies are preferable because they provide the most protection for homeowners against foreclosure. Both of these options should be available to homeowners facing foreclosure, especially for those with low or moderate incomes.

The guiding principles of government anti-foreclosure policies should be: (1) homeowners should be allowed to stay in their homes; and (2) there should be no bailouts for the lenders. And the long-run objective of government housing policies should be: decent affordable housing for all.