Can’t pay or won’t pay?

Feb 19th 2009 WASHINGTON, DC From Economist.com Barack Obama’s team wades into a debate over what is driving foreclosures AFP NO PART of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better. Now it is Barack Obama’s turn. On Wednesday February 18th he pledged $75 billion to reduce the mortgage payments of homeowners at risk of default. Lenders who help people to refinance their mortgages will receive matching subsidies from the government. These could reduce a borrower’s monthly payments to as little as 31% of their income, and last for up to five years. Firms that service mortgages held by investors will also receive fees for successful modifications. As a stick, Mr Obama reiterated his intention to alter the bankruptcy code so that courts can reduce mortgage principal. The details will depend on negotiations with Congress. Some 5m homes have entered foreclosure in the past three years. Credit Suisse estimates that over 9m more will enter the process in the next four years. (In normal times, new foreclosures run at fewer than 1m a year.) Mr Obama predicts his plan will prevent up to 4m foreclosures. In a separate initiative, up to 5m borrowers will be able to refinance their mortgages at lower rates even if their equity is less than the 20% usually required by Fannie Mae and Freddie Mac, the now nationalised mortgage agencies. Previous, less ambitious, efforts have flopped. George Bush’s first plan aimed to help up to 240,000 delinquent subprime borrowers refinance their debts into government-backed fixed-rate mortgages. Only 4,000 did so. A Democrat-inspired $300 billion plan to guarantee up to 400,000 mortgages attracted just 517 applications, as lenders balked at the requirement that they first write down the principal. Private-sector programmes have achieved higher numbers, but their success is mixed. Of 73,000 loans modified in the first quarter of last year, 43% were again delinquent eight months later (see chart). Mr Obama’s chances of being any more successful depend on whether his team has correctly diagnosed what is driving the wave of foreclosures. Is it that homeowners cannot afford to pay; or is it that they are declining to do so, because their homes are now worth less than their mortgages, the phenomenon known as negative equity? Both factors play a part, but economists are divided on their relative importance. One school thinks that, even in cases of negative equity, most homeowners will not default if they can afford the payments—not least because defaulting will wreck their credit records. A second school believes that once the home is worth less than the mortgage, homeowners have a significant incentive to walk away even if they can make the payment, since in many states lenders cannot then pursue them for the shortfall. Mr Obama’s advisers were drawn to the first school, in part by a Federal Reserve Bank of Boston study that found that when home prices fell by 23% in Massachusetts between 1988 and 1993, only 6.4% of borrowers with negative equity ended up in foreclosure. The authors concluded that most such borrowers felt what they got from their home was still worth the payment. The advisers were also influenced by the Federal Deposit Insurance Corporation’s apparent success in reducing the payments of delinquent customers of IndyMac, a failed bank. In a matter of months, 10% of the bank’s 56,000 seriously delinquent borrowers had their payments reduced to 38% or less of income. But others question the likelihood of success without reducing the principal. Edward Pinto, an independent financial industry consultant, estimates that 20% of borrowers with negative equity went to foreclosure in the past three years, in part because they started out much less creditworthy than their counterparts in Massachusetts two decades ago. If negative equity is the real problem, principal will have to be reduced to stem the foreclosures. But lenders are reluctant: they worry that many homeowners who can afford their payments will choose to default, or that investors in the loans will sue them. With house prices still falling, many borrowers would soon have negative equity again. And the write-downs, whether voluntary or court-ordered, could destroy the lenders’ capital. Aggregate negative housing equity is thought to top $500 billion. The government could absorb some or all of this, but at an astronomical and politically unpalatable price. In truth, both lower payments and lower principal would help reduce foreclosures. At present, banks aren’t doing much of either. Last month Communities Creating Opportunity, a non-profit group in Kansas City, Missouri, invited representatives of Bank of America and Countrywide to negotiate loan modifications with local customers. Damon Daniel, an organiser, says none of the 16 who applied got a write-down, though some might have their mortgages converted from an adjustable to a fixed interest rate. Leslie Kohlmeyer and her husband fell behind on their payments two years ago when his construction business dried up. He eventually found new work and they resumed payments, but could not pay their arrears. Three days after Christmas, Countrywide notified them of foreclosure. Ms Kohlmeyer went to Mr Daniel’s event, where a Countrywide official arranged to suspend the foreclosure; her arrears were added to the loan balance, and her monthly payment went up by $20. She thinks she’ll be fine. Unless either she or her husband lose their jobs.