An Economic and Political Primer on the Administration's Plan for the Housing Crisis

President Barack Obama today announced a plan to cut foreclosures and reboot new mortgage financings, at least when the economy shows signs of new life. The fact of offering a plan is an advance, given that Bush and his people did nothing and proposed nothing, even as the crisis reached critical mass. As we have written here since the crisis first broke, keeping people in their homes is fundamental to solving the larger economic problem. Again, it’s the fast-rising foreclosures and mortgage delinquencies that are eroding and destroying the value of hundreds of billions of dollars in mortgage-backed securities and the credit default swaps that “back them up” (sic). And it’s the falling value of those securities and swaps, in turn, which has led to the effective bankruptcy of financial institutions that had leveraged themselves to their eyeballs to buy them or issued them and then kept them (and how dumb was that?).

While the act of proposing anything serious puts the Obama Administration ahead of its predecessor, passing such a low threshold is hardly very meaningful -- especially since the problems continue to worsen. More than nine percent of mortgages today are either in foreclosure or delinquent, two to three times the numbers from just two years earlier; and if everything continues to unravel, those numbers could double in another year. If that happens, there won’t be many large, U.S. banks left standing. Many of the homeowners now in trouble could manage, if they just could refinance at current rates. But banks quite naturally see someone in financial trouble as a poor credit risk for a new loan, which is what refinancing is. And the fall in housing prices means tens of millions of those people can’t qualify to refinance. That’s because refinancing is available today only if you owe no more than 80 percent of the original mortgage’s value. The catch for millions of families is that as the value of their home goes down, their existing mortgage (the one being refinanced) accounts for a greater percentage of the value being refinanced. In the worst cases, people just walk away from a $200,000 home with a $300,000 mortgage -- and who would refinance one of those? In millions of other, less extreme cases, the falling prices simply disqualify people for refinancing.

The Administration wants to address this precise part of the problem, by providing $75 billion in subsidies to banks to defray half of the cost of refinancing for several million homeowners at risk of losing their homes. Mortgages owned by Fannie Mae and Freddie Mac are also eligible here, and they’re the ones most likely to actually see their interest rates reset, since the government owns Fannie and Freddie and can direct them to do it. It will be harder to convince bankers already staring at enormous losses already on their books or soon to be there, especially if they’re worried that their bondholders could sue them for resetting loans. The plan also has some $100 billion for the Treasury to keep buying more of Fannie and Freddie’s failing mortgage-backed securities since, as we also have said repeatedly, until foreclosure rates return to normal, the biggest bank bailout in the world won’t prevent more banking losses.

There are more direct ways to address foreclosures. We could provide direct loans to tide over those in trouble, or Fannie and Freddie could reset the loans of everyone in trouble. The problem is that anyone advancing such a common sense approach would become a very large political target -- and not just for reflexively-critical House Republicans.

How could the president or his advisors explain to those who work hard and spend less, so they can keep their mortgage payments up to date, why they don’t qualify for a lower interest rate from the government, when their neighbor who spent more or just had harder luck does qualify? More plainly, how does the government choose who would qualify for such direct help without enraging most of those who wouldn’t? In effect, the Administration plan finesses this problem by letting banks choose, without compelling them to do so. But what if the economy continues to worsen and the plan doesn’t work, which is a very real possibility? Indeed, don’t be surprised to see the Administration revisit it six months from now with a much less “voluntary” approach.