Home Underwater? Walk Away from Geithner's Perverse 'Homeowner Relief' Plan

The homeowner relief plan adopted by President Obama and Treasury Secretary Timothy Geithner has not been working for a full year now. What's worse, as the program is currently structured, its chief benefits accrue directly to the nation's largest banks, leaving troubled borrowers to twist in the wind. But despite the administration's indifference, underwater borrowers can still take matters into their own hands. If you owe more than your house is worth, just walk away.

"The rational thing for these people to do is to send the keys to the bank and say, 'Good luck,'" says Dean Baker, co-director of the Center for Economic Policy and Research. "Every month that you keep that person in their home paying that mortgage, that's a gift to the bank. So if you could keep a lot of people from sending their keys to the bank, and keep sending their checks instead, that helps the banks directly."

According to the administration's latest update on the Home Affordability Modification Program, just 66,456 borrowers have received a permanent mortgage modification from their bank over the past year, out of about 900,000 trial modifications. Even judging from the trial-stage figures, the program barely making a dent in the actual problem. Data from First American CoreLogic indicate that for 10.7 million U.S. homes, borrowers owe banks more than their house is worth (they're "underwater"). That's a full 23 percent of all mortgages in the country. Another 2.3 million borrowers are down to their last slivers of equity.

But the primary problem is not that the administration's program isn't reaching enough borrowers—it's that the "relief" offered by the plan is actually worse for a lot of borrowers than outright foreclosure. And despite heavy criticism from community groups and borrower advocates, Geithner's Treasury Department—which oversees the plan—has refused to alter HAMP's core objectives, opting instead for a series of minor paperwork processing tweaks.

HAMP attempts to keep people in their homes by reducing how much they have to pay every month. Banks can make all kinds of revisions to the loan contract to bring down this payment, and on the few permanent loan modifications that have been agreed to, borrowers have seen their monthly payments go down by about $500. But buying a home is so expensive, especially at bubble-level prices, that even borrowers receiving this aid could usually rent a comparable home for less. Still more troubling, this payment assistance does nothing to address borrowers' overall debt burden. The total amount the borrower owes to the bank—the loan principal—is still exactly what it was when the mortgage contract was first signed. If you bought your house for $280,000, but the house is now worth only $210,000, paying off your mortgage in full, even with help from HAMP, will mean losing $70,000.

"You can't make a significant dent in mortgage defaults without reducing principal," says Raj Date, a former Capital One executive who now heads the Cambridge Winter Center for Financial Institutions Policy.

The average underwater borrower today owes about $70,000 more than their home is actually worth, according to CoreLogic. Since 10.7 million mortgages are currently underwater, the banking system could see losses of up to $749 billion from problem mortgages—and the number gets much bigger if home prices decline further. Banks have probably already booked some of those losses, but it's still a huge hole, one many banks will not be able to fill. The entire U.S. banking system only has about $1.25 trillion to absorb losses, according to the Federal Reserve ($11.58 trillion in assets minus $10.33 trillion in liabilities). So while most large banks booked big profits and paid out huge bonuses in 2009, the potential for serious financial trouble has always been right around the corner. We have not, in fact, fully revived the U.S. financial system. We've just helped banks book profits on the backs of troubled borrowers. With HAMP, we've even encouraged borrowers to waste their money on irrational payments.

So it's no surprise that banks are extremely reluctant to wipe out principal for borrowers in trouble. "If you require principal reductions, that's a big hit to the banks," Baker says. "But a mortgage program where you're even putting up taxpayer dollars to help people pay more than their homes are worth, and paying more than what they'd pay to rent the same place—that's a real gift to the banks. If you ask who wins in this story, well, the banks win."

Borrowers don't usually think seriously about walking away from their homes until their payments become unaffordable. If the bank won't face up to reality, and the Treasury Department insists on looking the other way, walking away can save you a lot of money. And the sooner you walk, the harder it hits your bank—they're hoping you'll take on credit card debt and hit up family members to make a few more payments before you lose the house anyway.

But even people who can afford their monthly payments should be reluctant to give $70,000 or more to a bank for no reason. Walking away from an underwater home—even one you can afford—isn't illegal or immoral. It's written right into the mortgage contract: If you can't pay the debt, the bank gets the house. "Personal responsibility" doesn't mean further subsidizing the banks that your tax dollars already bailed out. In corporate real estate transactions, companies walk away from bad investments all the time. Sure, it's bad for your credit score. But is your credit score worth $70,000? Credit scores eventually recover-- $70,000 doesn't just fall out of the sky.

"There's a tipping point here on borrower behavior that we haven't yet reached," says Date. "When we get there, banks are really going to wish they'd played ball earlier."

There's only one scenario in which the U.S. economy avoids millions of foreclosures without cutting principal for millions of borrowers: A massive and rapid run-up in home prices. Treasury officials did not respond to requests for comment to this story, but there's some evidence that Geithner really does believe home prices will come roaring back. This past summer, Geithner couldn't get a price he liked for his home in New York, so instead of selling the house and taking a loss, he rented it out. He still hasn't sold the property, indicating he believes it's better to wait for home price gains than to sell at the current market value.

The decline in home prices has moderated somewhat in recent months, but overall, home prices are down about 30 percent from their bubble-peak levels, according to the Standard & Poor's Case-Shiller home price index. If prices were to suddenly surge and make back those losses, then millions of currently underwater borrowers would find themselves in a much more profitable position.

Economists are split about how much further home prices have to fall. But there's little reason to believe that home prices are going to shoot up. The very definition of a bubble is a situation in which prices are artificially elevated.

"People are talking about how they're going to bounce back, and it reminds me of when the NASDAQ plummeted from 5,000 to 3,000 back in 2000," Baker says. "All these people were talking about how it was going to come back, and I just don't know what they were smoking....It's just wishful thinking without any basis in reality."

So if home prices aren't going to suddenly skyrocket for no reason, then we're going to see a lot of foreclosures. And it will be better for borrowers and the economy to walk away sooner rather than later—they'll have more money to spend on other stuff.

Of course, the best solution here would be for Congress and the Administration to make the banks recognize the losses they're going to take from their bubble lending without making you move. Treasury doesn't have a whole lot of leverage over major banks now that it has allowed them to pay back the funds they received under the Troubled Asset Relief Program. But if Congress would change the consumer bankruptcy laws to allow mortgage debt to be renegotiated in bankruptcy court, we could get the same effect from a judge. The fact that mortgage debt is exempt from ordinary bankruptcy proceedings has always been both bizarre and unfair.

"If you really were serious about reducing foreclosures, you would do it by refining the consumer bankruptcy process," says Raj Date. "Bankruptcy is the legal mechanism by which we weigh the competing claims of different stakeholders."

Congressional leaders tried to change the bankruptcy laws last year, but President Obama did not fight for the measure, and the bill succumbed to a filibuster launched by Republicans and corporatist Democrats.

But if our politicians won't go to bat for you, you can always just walk away.