First Step in Solving the Subprime Mortgage Problem (Updated)

While it seems to me obvious, apparently it isn’t all that obvious. The first step in solving the subprime mortgage problem is to define what problem you’re trying to solve. In the Wall Street Journal today Martin Feldstein has a proposal for solving the problem:

The federal government would lend each participant 20% of that individual’s current mortgage, with a 15-year payback period and an adjustable interest rate based on what the government pays on two-year Treasury debt (now just 1.6%). The loan proceeds would immediately reduce the borrower’s primary mortgage, cutting interest and principal payments by 20%. Participation in the program would be voluntary and participants could prepay the government loan at any time.

The legislation creating these loans would stipulate that the interest payments would be, like mortgage interest, tax deductible. Individuals who accept the government loan would be precluded from increasing the value of their existing mortgage debt. The legislation would also provide that the government must be repaid before any creditor other than the mortgage lenders.

Although individuals who accept the loan would not be lowering their total debt, they would pay less in total interest. In exchange for that reduction in interest, they would decrease the amount of the debt that they can escape by defaulting on their mortgage. The debt to the government would still have to be paid, even if they default on their mortgage.

Participation will therefore not be attractive to those whose mortgages that already exceed the value of their homes. But for the vast majority of other homeowners, the loan-substitution program would provide an attractive opportunity.

Although home owners may recognize that the national average level of house prices has further to fall, they do not know what will happen to the price of their own home. They will participate if they prefer the certainty of an immediate and permanent reduction in their interest cost to the possible option of defaulting later if the price of their own home falls substantially.

That’s the meat of the proposal but I encourage you to read the whole thing.

What problem is Mr. Feldstein trying to solve? Apparently, he’s trying to forestall a collapse in housing prices as a result of foreclosures causing the market to overshoot on the downside:

The potential collapse of house prices, accompanied by widespread mortgage defaults, is a major threat to the American economy. A voluntary loan-substitution program could reduce the number of defaults and dampen the decline in house prices — without violating contracts, bailing out lenders or borrowers, or increasing government spending.

The unprecedented combination of rapid house-price increases, high loan-to-value (LTV) ratios, and securitized mortgages has made the current housing-related risk greater than anything we have seen since the 1930s. House prices exploded between 2000 and 2006, rising some 60% more than the level of rents. The inevitable decline since mid-2006 has reduced prices by 10%. Experts forecast an additional 15% to 20% decline to correct the excessive rise. The real danger is that prices could fall substantially further if there are widespread defaults and foreclosures.

Will Mr. Feldstein’s plan solve that problem? It might—by subsidizing borrowers a little. And it might not depending on how much of the run-up in housing prices are a consequence of speculative fizz—that’s gone anyway. That’s the criticism levied by Megan McArdle:

The main problem in most housing markets seems to be, not foreclosures, but the simple fact that people are no longer under the delusion that house prices will go up 5-10% per annum. In 2005, people were pricing that into their housing purchase: “Well, it’s worth maybe $300,000 to me, but of course, in three years, the house will be worth $450,000, so I could pay $375,000 and have a nice nest egg.” Now that the expectations of asset-price inflation are gone, prices have to fall back to the “real” value of the house: what it is worth to someone to have a warm, dry abode of their very own to live in. Actually, a little farther, because the credit contraction means that there’s a large mismatch between supply and demand.

Foreclosures might cause the price collapse to overshoot on the downside, but I don’t see them as the primary driver, even in depressed markets.

But the one thing it would definitely do is indemnify lenders against the consequences of their own folly. That’s the criticism levied by Arnold Kling:

It is hard for me to see this as anything other than a lender bailout. It does give borrowers a subsidy, based on the fact that the government can borrow at low interest rates. However, the main effect is to take risk off the table for lenders. They would immediately receive 20 percent of the outstanding balance on loans that are of high risk for default.

The problem I think is most in need of solving is the actual underlying cause of the problem which seems to me to be a problem with incentives in the financial services industry and the use of mortgage bundling and resale as a means of removing mortgages from the banking sector in which solvency, credit worthiness, and accounting standards are quite strict and regulated to the broader financial services industry which doesn’t receive nearly as much scrutiny. I don’t see that Mr. Feldstein’s proposal addresses either of those problems.


Mark Thoma brings up a point I thought of myself. Under Feldstein’s plan how would the government handle default?

There is one aspect he doesn’t mention. I’m not quite sure how the government avoids default risk without substantial loan collection costs, and even with aggressive and costly collection not all default can be avoided. I suppose the government could take future tax returns, Social Security payments, etc. in the case of default, but each additional restriction the government puts in place to protect itself will make the loans less popular and limit the program’s effectiveness. The government could also avoid any losses from defaults by setting the interest rate high enough (spreading the losses among borrowers), but the higher interest rate would also limit participation. In the end, it’s hard to imagine the government not taking some losses from this program, especially if participation is widespread, and the since the losses the government absorbs would be seen as some sort of bailout to lenders, the proposal would likely face political opposition.

10 comments… add one
  • PD Shaw Link

    The second step might be to evaluate whether it is a federal problem or state problem. I look at this map and think that a national policy could exacerbate problems in some areas. And I question whether the source of the housing problem in say Southern California is the same as Memphis or Detroit. And I also suspect by looking at the map that state policies are partly to blame (such as California property taxes encouraging people to spend as much $ as possible to lock into a lower property tax rate).

  • I think that’s probably true, PD. One of the many good things about a federal system is that state governments can focus their attentions on the conditions in their respective states.

    That’s something I’ve written about with respect to another of the crises we’re fretting about these days: the crisis of those without medical insurance. Turns out that much of the problem is in just six states and those states have more uninsured than their populations would suggest is typical.

  • I fail to see how his plan avoids the issues he appears to see in the Depression era structure. Large federal bureaucracy. One way or another, there would be a need for staffing and analysis, as the defaults issue, etc. requires management.

  • Ah, mate, this is a nice analysis of the plan, from The fine fellows at Calculated Risk.

    Magical thinking, I believe would be a good summary of the plan.

  • CR’s analysis is good and supports my intuition that the plan does very little for borrowers and significantly more for lenders. If the problem trying to be solved is to reduce the risk of the lenders, this would do it but it seems to me the problem at hand is that too many lenders weren’t taking risks seriously as it was.

  • Agreed, entirely.

    That and risk was off-loaded willy-nilly in very untransparent ways. The US has managed to take the entirely decent idea of securitization and turn it into a Frankenstein monster.

    Further then entire concept expressed in the plan that it would not need a “federal bureaucracy” is just plain magical thinking (as CR rightly mocks). One suspects rather soon there will be quite a number of semi-skilled housing financing people on the market….

  • The problem with Feldstein’s proposal is that it would cost the homeowner MORE per month.

    Old Payment:
    200K 30 yr mortgage @5.5% P&I = 1135/mo
    New Payment(s)
    160K 30 yr mortgage @5.5% P&I= 908/mo
    40k 15 yr Gov Loan @1.6%=250/mo
    New total= 1158/mo.

    As to how the gov’t handles default, it’s in an early paragraph of the story, they would secure the loan to you with FUTURE WAGES. In otherwords, if you default on the government portion of the loan they attach your paycheck to get their money.

  • Thomas Jackson Link

    This is the result of the Federal Govt’s meddling with its Community Redevelopment Act that forced banks to loan to questionable borrowers or else. Combine this with Fannie May’s questionable loan practices for years and you have no interest loans, jumbo loans and as the WSJ stated a loan to a maid and casual laborer (illegal aliens both) for 700K.

    Now the Federal Govt wants to step in to protect these people? Just follow the money trail people.

  • Eh, what are you on about mate?

    The American Federal Government has fuck all to do with your housing loan crisis. Good bloody fucking lord, how stupid are you people? Never mind, I see you’re a bloody idiot bigot, going on about ‘illegals’ irrelevantly.

    No doc and other questionable loans did not pass through your federal guarantee program – if they did that would have been fine, and a purely American problem.

    No, much of the problem lending was pure private sector, via non-Bank specialist lenders, generally with non-national (federal) licenses, at the State level, and thus not fully (or at all) subject to proper regulatory oversight by Central Bank (or the mind boggling balkanisation of federal authorities you have). Said sub-Prime loans, again largely generated by non-Bank institutions via purely private market channels, were packaged as securitised instruments – pools of loans which our models thought were risk mitigating (that was a pure market fuck up mate, fuck all to do with your federal government, although perhaps indirect perverse incentives via new bank regulation focused on leveraging market based risk assessment).

    I’d be happy to see you morons go down had the US not sold on this rubbish to the global market. But your loss of face. You bloody well want to blame it on your Federal government, go ahead, idiot. Or illegal aliens. both had fuck all to do with the issue.

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