Free Money if You're Underwater

By Dave Fratello | March 4th, 2008
Sagging under the weight of that giant mortgage?

Thinking about walking away and sticking faceless "investors" with your problem?

Don't move too fast! The Fed wants your bank (or those faceless "investors") to give you some free money to make that debt just a little less burdensome.

Here's how it works. Say you can't pay afford your $800k mortgage, but maybe you could make payments on a $600k mortgage. Great! We'll chop $200k off the mortgage. Then you won't default, and everyone comes out ahead.

You see, freezing interest rates and postponing recasts on interest-only loans to keep those loans affordable isn't going to be enough to stem the foreclosure tide. We know because Ben Bernanke says so:
Although lenders and servicers have scaled up their efforts and adopted a wide variety of loss mitigation techniques, more can, and should, be done... This situation calls for a vigorous response.
Bernanke knows that the tide is only beginning to come in.

People aren't just foreclosing because their payments have jumped. They are making the judgment to walk away because they're "underwater" – they already owe more than their homes are worth, and the housing correction has only just begun. They see the tide coming in and expect to get stuck even deeper below the surface.

So don't just throw them a lifeline, Bernanke says, bail out some of the water:
When the mortgage is ‘underwater,’ a reduction in principal ... that restore[s] some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.
Ben's plan makes some sense. If homeowners have some skin in the game, and some hope that they'll eventually have lasting equity in the home, they might not walk.

(Funny, more homeowners might already have had some skin in the game if they had put up significant down payments, not 0-5%, or hadn't been allowed to leverage their home's paper value up to 125% with equity lines, etc. But that's the past, no sense revisiting it now.)

Bernanke can't impose a solution. He's pitching this as "relatively more effective" and ultimately a net benefit to lenders/"investors." He's encouraging them to see that the hit from a foreclosed loan would be worse than the loss from a voluntary write-down. And in some cases, that's undoubtedly true. (Probably more so in the next year or two.)

Of course, if you chop someone's loan once to get them out from underwater, they might expect the same the next time there's trouble. More free money! Bernanke acknowledges this:
[Lenders] say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again.
This is a form of "moral hazard" – writedowns encourage more risky behavior by borrowers in the future, without really protecting the lenders. And it's not exactly fair to the folks who bought homes at other times with less risky LTV ratios. (Sorry, responsible homeowners, you're not in this game.)

That the Fed chairman is proposing something so difficult and noxious, with such blatant downside risks, should be startling. It's an indirect way of communicating that the Fed is very, very... very worried.

Ben seems to have taken by surprise the former Goldman Sachs CEO, Henry Paulson, who currently serves as Secretary of the Treasury:
While these equity considerations clearly impact homeowners’ financial situation, they are not the primary concern in the effort to prevent avoidable foreclosures.
They're not part of Paulson's strategy at the moment, but then, he's walking in step with the lenders. Paulson is all for a housing correction and seems more inclined than Bernanke to let the bad loans to bad borrowers go bad ASAP so we can start over.

But we may be entering a time soon when people will be looking for anything at all that floats.

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