Top-Down Solution

By: NAR Chief Economist Lawrence Yun

March 10, 2008 - There are several policies that have been proposed, and some already in place, to address rising foreclosures.  Nearly all are attempting to alleviate the problem by approaching it bottom-up rather than top-down.

The bottom-up approaches involve a plan to work out current problematic loans.  The following are some of the proposals in very brief:

1. The FHA Secure program offered through HUD allows for people to get out of high-interest rate subprime loans into lower interest rate FHA loans if people meet certain conditions - including having some level of housing equity and having demonstrated timely mortgage payments prior to facing higher resetting rates.
2. Sheila Bair of FDIC was one of the first to call for voluntary loan remodification.  A lender's profit margin will be lower, but it is still better for the bottom line than with a foreclosure. Recently, she called for systematic lowering of resetting of rates on 2/28 and 3/27 subprime hybrid loans. 
3. Henry Paulson, Treasury Secretary, called for essentially the same after bringing key financial institutions together and making the voluntary loan restructuring into more concrete form.  There are a lot of hoops a borrower has to go through to qualify for the relief, however.
4. Ben Bernanke has suggested for lenders to give a break to distressed borrowers by lowering of some portion of the loan amount.  A lower remaining principal will permit more manageable monthly mortgage payments for borrowers.  More importantly, a principal write-down changes the homeowner's position from being underwater (negative housing equity) to above water.  Incentive is now to make payments rather than walk away. 
5. Senator Chris Dodd has made a legislative proposal that would permit bankruptcy judges to modify the loans that make payments more manageable. 
6. Martin Feldstein, Harvard University professor, made an intriguing proposal of immediately substituting 20 percent of the existing loan balance into very low interest rate loans.  The federal government will provide the exceptionally low rates. 

All of the proposals are well-intended and most will help mitigate foreclosure problem.  But in addition to some aspects of the bottom-up solutions, what is needed and could well be far more effective is a top-down solution of raising the housing demand.  As I wrote earlier, what is most needed in the current point in the housing cycle is to get the home sales rolling.  Rising home sales will lower inventory and lower inventory will help quickly stabilize home prices.  A recent Boston Fed study showed that home price movements and not interest rate resets as the primary determinant of foreclosures.  If people have less or negative housing equity, then people have an incentive to default on mortgages and simply walk away. 

There is plentiful pent-up demand.  The difficult part is getting this demand unleashed into the marketplace, due the pervasive consumer pessimism related the housing market.  The raising of the loan limit on FHA and Fannie/Freddie backed loans will help unleash some of that demand as more people will have access to lower interest rate loans.  Lower home prices can also work to bring buyers to the market, but it is no guarantee because lower prices can also add to excessive pessimism and raise foreclosures. 

What is critically needed at this important point in the housing cycle is a measure to assuredly and quickly raise home buying activity.  This can be accomplished by providing a homebuyer tax-credit.  A nationwide $5,000 tax credit (the same amount currently in existence for homebuyers in Washington, D.C.) will cost the federal government $40 billion.  If factoring in rising economic activity and accompanying rising tax revenue, then the true cost could be minimal or even positively favorable.  A reversal in the weakness in the housing market, which has been subtracting about one percentage point off GDP growth, can add $40 billion to the U.S. Treasury - essentially offsetting the cost of the tax credit.  If the initial $40 billion cost is harder to swallow than a more targeted tax credit for only the first-time homebuyers will cost the government about $15 billion. 

The ongoing subprime loan mess is due to past lending problems.  Current homebuyers are not exposed to these past lending mistakes.  These fresh buyers will be the ones saving the day for homeowners who are underwater.  Rising demand lifts all boats.  There is a wide selection of safe mortgage products for today's homebuyers.  Combine that with a homebuyer tax-credit and we have a making of a solid housing market recovery.  As housing nearly always leads the economy, a solid economic recovery will not be far behind.

Copyright National Association of REALTORS®, Reprinted from REALTOR.org with permission.

  
© 2007-2008 Heather Tawes Nelson

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