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Weak Medicine: Obama's Flawed Plan for Reforming the Banks

The Treasury Department is caught between two opposite and incompatible goals: It must maximize bank earnings while simultaneously diverting the housing market's nosedive.
 
 
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Editor's note: The following is an excerpt from A Presidency in Peril: The Inside Story of Obama's Promise, Wall Street's Power, and the Struggle to Control our Economic Future by Robert Kuttner.

When Barack Obama entered office, the housing crisis required very strong remedies. Government needed to use a mix of public funds and concessions on the part of the bankers and investors, who held the mortgage paper, to reduce the principal and interest to a monthly payment low enough to allow distressed borrowers to keep their homes. Otherwise, the foreclosure crisis would keep feeding on itself, glutting the market with vacant homes, driving housing values still lower, and trigger¬ing still more foreclosures. But this course would require banks and hold¬ers of mortgage-backed securities to take losses, and it was rejected by both the Bush and Obama administrations. Instead, both Bush and Obama relied on a series of voluntary programs, jawboning bankers to reduce monthly payments. Not surprisingly, this approach failed.

Back in 2007, looking over the brink of this precipice, the Bush admin¬istration had worked with the banking industry to develop the first volun¬tary program, called the HOPE NOW Alliance. The group claimed that member banks participated in 2,911,609 “workouts” (reductions of monthly payments) between July 2007 and November 2008, but that number turned out to be grossly inflated. Only 37 percent of the workouts resulted in modi¬fication of the loan terms, and of these only 49 percent actually cut monthly payments. Most of the reductions were modest.

According to the definitive study of the program by Professor Alan White, 34 percent of the modifi¬cations actually increased costs to the borrower. Lenders discovered that in restructuring a loan, they could profit by charging up-front fees. Since 2007, under Bush and Obama alike, the pace of new foreclosures has far outstripped the number of loan modifications.

In July 2008, Congress attempted stronger legislative medicine. A program called HOPE for Homeowners authorized the Federal Housing Administration to insure distressed mortgages if private lenders would provide refinancing. But subprime loans are deliberately structured to extract a large prepayment penalty if the borrower refinances. Many of these loans now had negative equity—the loan was worth more than the property—and lenders balked at refinancing even with the FHA insurance. When the HOPE for Homeowners program was enacted, its sponsors predicted that it would help 400,000 homeowners—not nearly enough compared with the millions of defaults. But by February 2009, the scheme had processed exactly 373 applications and closed just 13 refinancings. Hardly any of the distressed properties fit the terms of the program. “HOPE for Homeowners has been a failure by virtually every metric,” declared Representative Spencer Bachus of Alabama, the ranking Republican on the House Financial Services Committee—describing a program signed by a Republican president.

By the time Obama took office, serious defaults and foreclosures were on track to reach more than 8 million during the new president’s first term. This was a moment for a radical break, yet Obama’s plan basically contin¬ued the Bush administration’s voluntary approach, lubricated by $75 billion in government incentive payments to banks. The Obama variation has also been a complete failure, adding to the general economic downdraft.

Obama’s program, called Making Home Affordable, was announced February 18, just four weeks into the new administration. The plan had four major parts. One, a more liberal variant of the old Bush program, allowed homeowners with mortgages to refinance their loans with FHA insurance, even if the outstanding loan was worth 5 percent more than the current value of the house. In July 2009, this ceiling was increased to a premium of 25 percent, meaning that a borrower with a $200,000 home could qualify for a $250,000 mortgage—something inconceivable in ordinary circumstances. This unprecedented remedy of encouraging a homeowner to borrow more than the value of the house was itself very risky, since a homeowner with negative equity loses nothing by just walking away if a better housing option becomes available. Millions did, leaving banks stuck with vacant homes.