Thursday, March 12, 2009

Obama’s housing plan needs to stop homeowner walkaways – but will it?

Barack Obama’s housing plan takes some steps towards stemming the housing crisis but has several major issues.   Overall however, the plan will not completely stop people from walking away from their homes when they are under water, and thus may not fully end the housing crisis.   The crisis is self-reinforcing until housing price declines end.  George Soros predicted that this us what it would come to, and perhaps said it best in his book, a point that he reinforced at his talk at MIT.  His quote:

“Eventually, the US government will have to use taxpayer’s money to arrest the decline in house prices.  Until it does, the declining will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent, thus reinforcing both the recession and the flight from the dollar.”  (George Soros, Economist 10/23/2008)

Soros predicted that this housing bailout would be necessary, and that it is integral towards stemming the problems of the economy as a whole and helping the financial sector.  The Obama plan has three parts.  One helps homeowners who are current on their payments, but they are paying high interest rates and do not have any equity.  These people are on the verge of falling off the cliff.  An illness or losing their job would push them off the edge.  Obama’s plan will provide incentives for mortgage servicers to modify these loans to reduce the % of income.  Another part of the plan helps those who are really at risk of being foreclosed on.   Another pushes up the amount of credit available for mortgages by giving $200 billion to Fannie Mae and Freddie Mac.   (New York Times, 2/19/09)

America's Walkaway Problem

Obama’s plan improves the health of the overall system with this injection of capital, but ultimately, the US mortgage system has a major flaw that Lester Thurow pointed out to me during our time together at MIT.  In other countries, collateral for mortgages does not include only the home, but also future streams of income.  This prevents people from walking away from their homes when they are underwater.  So long as people can walk away from a home that is under water, they will, and housing costs will fall.  That means that systematically, there will be more foreclosures as prices fall.  

If Obama can stop walkaways, then an injection into reviving the credit market should stimulate buyers to re-enter the market.  It must be noted that the demand for housing has not truly fallen off a cliff.  While incomes have fallen somewhat, Americans have not decided that they do not want quality housing.  In many tight housing markets like Boston, rents have risen significantly.  The renter/owner dynamic has shifted towards rentals because potential homebuyers have stayed out of the market rather than “trying to catch a falling knife”.  The environment creates a sense of fear for these buyers – it may be that their rents are more than what their mortgage payments would be (if they could get credit), but it is easier to get out of rental than a mortgage and in this environment, that is enough to keep them out of the market.  When they are sure that prices will not fall anymore, they will re-enter the buying market so long as they can get credit and their economic circumstances permit it.  

How effective are mortgage mods at stopping walkaways?

Experts differ on how much mortgage modifications will help in terms of stopping walkaways.  In any case, it is never a 100% success rate.  In other country’s system, the debt follows you to your next job, so you ride out the housing market storm.  In a sense, this stimulus package is an entirely new experiment on giving modifications to different types of homeowners who are struggling.   We don’t know exactly what the rates of success of modifying these loans will be, especially if the overall economic downturn continues and people lose their jobs.  In 2008, with the economy struggling, the nations 14 largest banks had more than half the loans they modified delinquent again after six months.  That seems to point to a major flaw in Obama’s housing plan.  However, other evidence says that if you do the modification properly, less than 25% of loans become delinquent again.  (New York Times, 2/19/09)  The percentage difference there is massive.  There are 3 to 4 million at-risk homeowners, and a 25% difference is a million homes.  That is the difference between the plan successfully stemming the tide or having a minimal impact on reversing the home price decline.

It is probably illegal in the US to change the law to tie existing mortgages to future streams of revenue.  It would also probably be political suicide.  Furthermore, requiring it would probably keep even more people out of the credit markets.  So like social security, we’d probably like to have another system, but we’re stuck with the one we have.   

Conclusion

Obama’s plan is as Soros predicted, a US taxpayer funded attempt to stop the self-reinforcing decline in housing prices that is keeping the US from escaping this economic downturn.  The only question is whether it goes far enough.  This is already seen as a large package; however, it probably needed to be larger to full stop the cycle of decline.  Time and surrounding economic circumstances will only tell if it sufficient to fully stop people from walking away from their homes, and thus reinforcing the cycle.



For those who are interested, Soros' talk from the MITWorld channel:

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