Fixing the Housing Market

The scope of the problem in the American housing market is
illustrated by the statistics that total negative equity is presently
estimated at $750 billion, and about 15 million homes are
"underwater.“ (1)
One proposal gaining traction is the concept of a "free" principal
reduction for underwater borrowers. We argue that this and all
other government and policy proposals to "fix the housing
market" the last few years fail because they throw good money
after bad in targeting only the most distressed and riskiest
borrowers,
many of whom previously acted recklessly and/or may not be
able to stay in any home -- or even pay a modest rent -- without
outright government subsidies.

Such borrowers are beyond rescue and efforts to "save" them
are neither worthwhile nor truly aimed at helping the housing
market or the lenders whose credit is essential for real estate
finance.
We present a proposal which flips so-called conventional
wisdom on its head. Under our proposal, homeowners making
substantial prepayments of at least $50,000 would have their
principal reduced by two dollars for each dollar of prepayment.
Our proposal targets the most responsible and financially savvy
homeowners. These homeowners are also the likeliest to
strategically default on their mortgages, not out of fiscal
irresponsibility or immorality,

but out of economic rationality and a desire (however perverse)
to be treated equally and capitalize on disastrously misguided
government policies incentivizing irresponsibility.
A strategy that rewards the borrowers most likely to be the
bedrock of communities will discourage strategic defaults and
depress the supply of homes.
Meanwhile, the strategy helps the lending banks most
necessary for the healthy functioning of a real estate market
dependent on third party financing, thereby encouraging the
extension of mortgage credit to meet demand.
The ultimate recovery of the housing market requires the true
equilibrium between supply and demand.

The anemic demand of the past few years strongly indicates a
substantial decline in home prices from current levels is
necessary to boost demand and, barring a sustained economic
recovery that is unlikely in the current regulatory climate, may
be the only way to accomplish equilibrium.
THE ERROR OF THE CONVENTIONAL PARADIGMS
Current misguided (or Machiavellian) government strategies are
only encouraging banks to refuse to foreclose and encouraging
defaults, thus delaying the unavoidable price decline (if not a
second crash) and pushing the tsunami of pent-up supply
farther down the road so as to delay any recovery and prolong
the housing depression.

The key premise is that the housing market will recover only
when foreclosures stop and the supply of homes for sale
decreases. This is mistaken, for among other things it totally
ignores the demand side of the equation.
The problem is that foreclosures have been replaced by long-
time defaults whose homes are perceived to ultimately be going
on the market, hence supply has been pushed back and buyer
expectations are for future significant losses in housing.
Intelligent, rational prospective buyers who will willingly buy a
home while expecting its future value to decline quickly and
substantially shall be few and far between. In fact, efforts to
constrain the flood of supply have only depressed the demand,
and reduced the price point at which that demand arises.

By contrast, our strategy that fosters self-sustaining demand
while encouraging good homeowners to stay current on their
mortgages will discourage a flood of high-end real estate from
ever hitting the for-sale market.
This natural, permanent decline in a key driver of supply will
help stabilize the supply end of the equation and help the
housing market reach the equilibrium between supply and
demand necessary for recovery.
This will contrast with the disastrous mistakes of the last four
years. Banks are already, quietly, rolling out principal reduction
programs targeted at the worst credit risks, the homeowners
who have already become delinquent or who have already
defaulted.(2)

Principal reduction was once thought a radical plan but has
gradually gained acceptance; indeed, a 2010 draft study from
three economists at the New York Fed concluded that reducing
mortgage principal, instead of just reducing monthly payments,
was the most effective way to keep homeowners in their
homes. (3)
The banks are doing this only for mortgages which they hold
(they cannot force RMBS investors to agree to principal
reductions for the mortgages they own).
The banks are already willingly writing down the value of these
mortgages, without any return except the illusory risk reduction

based on the questionable premise that delinquent or
defaulting borrowers who could or would not make previous
monthly payments will start doing so for "more affordable"
monthly payments.
Under this arrangement, the banks consign themselves to
reduced cash flow, reduced principal, reduced collateral value,
and in our estimation, arguably at the very least, little to no
increased likelihood that the former delinquent borrower will
become and remain a good, on time payer.
This is writing down asset values -- in other words, destroying
wealth -- in order to help the segment of homeowners most
likely to redefault and be beyond help.

This strategy features no benefit, no return on investment, for
the banks. Principal reduction for the worst default risks will
only hurt banks and delay the inevitable foreclosures.
The sense of inevitability has already prevented value recovery
for the homes of their responsible neighbors, while condemning
entire neighborhoods to an indefinite prospect of wealth
destruction for as long as these pick-the-loser policies delay the
price declines necessary for the supply of housing to fall to the
price point at which buyer demand will naturally grow.
In the meantime, the sense of free and often undeserving relief
has encouraged other defaults, setting into action a downward
spiral

where fewer people stay current on payments, banks suffer
greater asset and income losses, and values continue to drop as
foreclosures set new lows for "comp" use (as comparable values
to use as benchmarks for value of other, nearby, similar homes),
in turn depressing buyer demand.
There is no apparent benefit to the banks from principal
reduction "for free." That is because the federal government
has begun to adopt the philosophy that private enterprise
needs only the benefit of being allowed to continue to operate.
In essence, the benefit is: do principal reductions, or else we
will regulate you out of business, and find crimes so we can
prosecute your management.

Indeed, the recent foreclosure settlement takes just this
approach (although its intent is nowhere as clearly stated as
here). (4)
There is another benefit. Let us be clear on this. The federal
government is encouraging banks to do principal reductions in
order to gain political support -- votes -- from those who will
believe this program is "relief" and "compassion.“
Just as Machiavellian, this same constituency will remain
dependent on the government for future relief. This is the
creation of a vicious cycle of dependency, whose victims
become trapped and ripe for exploitation.

Our proposal provides for bonuses on substantial prepayments
of first lien mortgages. A homeowner prepaying $50,000 would
qualify for a principal reduction, not of the amount paid, but for
an amount double the prepayment.
Even better, the proposal would not have hidden conditions,
trap doors and other negative aspects buried in "fine print.“
Our proposal succeeds in five ways:
(1) it fosters fairness and appeals to people's sense of fairness
and justice, by having equal treatment of all borrowers;
(2) it incentivizes responsible borrowers with a way to make a
quick, substantial return on investment;

(3) it reduces the default risk borne by mortgage servicers
(banks) which have to pay taxes and property insurance on
properties in cases of default;
(4) it reduces the default risk borne by the holders of the
mortgage -- either the originating bank or the investors holding
mortgage-backed securities -- which lose the cash flow and
principal repayment; and
(5) it reduces the temptation of the most financially savvy
homeowners -- typically also the ones with the highest home
values -- to engage in economically rational strategic defaults.
This proposal succeeds in five more ways than anything coming
out of the Obama Administration these past few years.

It is fair, effective and balances losses to banks and investors
with the benefits of a return of principal and resulting reduction
in risk of loss from borrower default.
SUMMARY OF THE PRINCIPAL REDUCTION PROPOSAL
The essence of the proposal is that all homeowners are eligible
for a prepayment bonus. This proposal would permit all
homeowners current on first mortgages with a remaining
principal balance over a set minimum amount of $50,000 to
qualify for a home loan principal reduction in an amount that
would be double their prepayment amount (which would be a
minimum of $25,000).

This proposal would have uniform terms offered on all first lien
mortgages (but not subsequent liens, such as home equity
loans) so there is "one set of rules" for all similarly-situated
borrowers.
The proposal would be in place for a specified period; for
simplicity and ease in application, this could be across one
calendar year. The proposal would give a homeowner who
prepays $25,000 a $50,000 principal reduction.
The incentive for borrowers would be an immediate return on
investment -- the prepayment -- of 100%. However, an
important feature is that this investment would not be "free
money" as it would not be without risk,

because the increased paid-in equity becomes subject to future
real estate value declines, so borrowers are trading in cash
(whose value is relatively constant, subject to inflation and
deflation) for property wealth that can suffer real equity losses -
- temporarily at least -- in the future.
Some parties benefit only modestly under this proposal. We
admit that we treat everyone equally, but cannot (and do not
even try to) achieve equal results.
The holder of the mortgage -- whether it be the bank or the
investor, typically the holders of a residential mortgage-backed
security ("RMBS") -- will suffer a current write down of the
mortgage asset and reduced future cash flow from mortgage
payments

but gets an immediate and significant -- and very real -- cash
infusion that will act as a partial return of principal and a
reduction in the liability of default risk. It is a two dollar asset
reduction for each one dollar liability reduction, but mortgage
holders get a relatively stable asset in cash.
(There is a value judgment here in that there are few assets
more stable -- if not necessarily very likely to appreciate -- than
cash, and that mortgages won't be repaid in commodities any
time soon.)
Banks worried about actual liquidity and compliance with
stricter capital ratios should welcome the receipt of additional
cash from this proposal.

Meanwhile, the value to mortgage holders is the certainty of at
least some return of principal.
RMBS holders get a small return of principal and lose cash flow,
while the remainder of their purchased "tranche" of so their
lost profit opportunity is greatest and risk reduction the least
from the prepayment of the mortgages perhaps least likely to
be defaulted upon and the most productive in cash flow terms.
However, our proposal does not need to incentivize mortgage
holders, so their acquiescence is unnecessary. At a minimum,
our proposal is certainly a far better deal for both homeowners
and banks that the landmark

And possibly catastrophic -- foreclosure settlement under which
the nation's five largest banks recently agreed to pay $20 billion
in the aggregate to the United States Department of Justice in
order to provide "relief" which the government contends will be
in excess of $20 billion. (4)
At the very least, the foreclosure settlement demonstrates the
banks' willingness to reduce principal on less than a dollar-for-
dollar basis as is the case with traditional prepayments. Our
proposal is vastly superior, because it provides banks with
liquidity from actual cash payments, and real risk reduction.
The proposal's effects on banks are also positive, but
understanding how requires knowing whether the bank issued
the mortgage (an "originator")

or is receiving the monthly payment and making periodic
disbursements of taxes and insurance (this bank is a "servicer") on
the mortgage.(5) Originators will lose future cash flow, but this is
a tradeoff of future, speculative profits on monthly payments
against the risk of default which exists until repayment.
Originators have contingent liabilities for contractual
representations as to borrowers' quality and suitability, and can
be subject to having to buy back nonperforming loans because of
false representations
(this is often the product of faulty, outright incompetent or
absolutely nonexistent due diligence, and less often a case of
fraud), so for originators a default is only a contingent, but larger,
liability that follows its already realized profit from selling the
mortgage.

While originators have obvious "skin in the game," more often
servicers -- which commonly are the too big to fail banks -- are
contractually bound to pay the property taxes and insurance if
the borrowers default. Servicers can -- and do -- face the
hammer of an endless money pit of monthly expenses (their
own real cash burn) while receiving no servicing fees.(6)
For servicers, a default is a triple loss: no fee income, the
assumption of real expenses for insurance and taxes, and
liability for property upkeep plus the risk of deterioration of and
damage to abandoned properties.
Banks are already, quietly, rolling out principal reduction
programs. These programs are targeted at the worst credit
risks, the homeowners who have already become delinquent or
who have already defaulted.

The banks are doing this only for mortgages which they hold (they
cannot force RMBS investors to agree to principal reductions for
the mortgages they own).
The banks are already willingly writing down the value of these
mortgages, without any return except the illusory risk reduction
based on the questionable premise that delinquent or defaulting
borrowers who could or would not make previous monthly
payments will start doing so for "more affordable" monthly
payments.
Under this arrangement, the banks consign themselves to
reduced cash flow, reduced principal, reduced collateral value,
and in our estimation, arguably at the very least, little to no
increased likelihood that the former delinquent borrower will
become and remain a good, on time payer.

Worst of all, this is writing down asset values for the segment of
homeowners most likely to redefault and be beyond help.
What does this do for the millions of homeowners who have
already defaulted? We admit that our proposal does nothing to
help "distressed" homeowners.
We believe most delinquent or defaulting homeowners cannot
and should not be saved, and that their homes should be
allowed to go through foreclosure as quickly as due process
permits.
We believe many delinquent or defaulting homeowners have
circumstances which call into doubt their ability to pay even
modest rent without receiving a government subsidy;

Hence, these people will not benefit from any level of principal
forgiveness because their ability to make monthly payments
may have been so seriously compromised that they may have
trouble paying rent at a level substantially less than their
mortgage payment.
In fact, some of these likely defaulters may be looking at years
of living rent-free in a home awaiting foreclosure, and then
additional years of living rent-free if they then become
delinquent (whether deliberately or by hardship) on rent.
However, there may be no solution for these homeowners
except to allow the economy to recover so they can become
economically self-sufficient, or to simply give them an outright,
full housing subsidy and not pretend that is anything but a
subsidy.

Our principal reduction plan should be implemented, both to
enhance banks' cash reserves at no expense to the taxpayer,
and reward responsible homeowners at a time when popular
faith in playing by the rules seems to be at an all-time low.
It is important to reaffirm the sense of fairness and "equal
treatment under the law."
Otherwise, the crime waves of tomorrow, engaged in by people
who may proclaim a Robin Hood-type of moral righteousness,
may rival the urban riots of the 1960s.
This is how we keep 21st Century America from descending into
chaos.

THE BIG PICTURE
A healthy housing market requires a balance between supply and
demand. There are numerous factors like the default and
foreclosure pipeline boosting supply well in excess of demand -- at
current price points. Almost all government intervention to date
(save for the short-term tax credit for home purchases in the spring
of 2010) has focused on suppressing supply, when it should be far
easier and cheaper to focus on boosting demand.
The easiest way to get more demand from the marketplace is
perhaps the simplest: remove all price supports and government
interventions to allow prices to fall to a natural point where
demand picks up naturally and buyers are no longer justifiably
worried that future price losses will wipe away any new equity
investment they make.

FOOTNOTES
1) Stan Humphries, "Universal Mortgage Principal Reduction:
Who's Going To Pay For This?" Zillow Real Estate Research
Brief posted Apr. 3, 2012, available at
http://www.zillow.com/blog/research/2012/04/03/universa
l-mortgage-principal-reduction-who%E2%80%99s-going-to-
pay-for-this/
2) Bank of America announced on March 12, 2012 a plan to
grant principal reduction to up to 200,000 borrowers who,
among other things, must be underwater and at least 60
days delinquent to qualify for principal reduction.
http://www.bankrate.com/financing/mortgages/bofa-
offers-principal-reduction/

3 ) Andrew Haughwout, Ebiere Okah and Joseph Tracy, "Second
Chances: Subprime Mortgage Modification and Re-default,"
Federal Reserve Bank of New York Staff Report No. 417
(Draft), December 2009.
4) "$25 Billion Mortgage Servicing Agreement Filed in Federal
Court," U.S. Department of Justice, Office of Public Affairs,
March 12, 2012. Each of the five banks (Ally, a unit of GMAC;
Bank of America; Citibank; JPMorganChase and Wells Fargo)
entered into separate consent judgments with the
Department of Justice, which judgments are accessible at
http://www.justice.gov/opa/opa_mortgage-
service.htm. The amount to be dedicated to homeowner
relief is an aggregate of $20 billion but the total payouts by
the banks was announced as $25 billion.

5) The mechanics and relationships between the various
parties in mortgage financing can be distilled by reference to
the registration statements and accompanying agreements
filed as exhibits to the registration statements
and other documents filed with the Securities and Exchange
Commission by various issuers of mortgage-backed
securities.
6) Kathleen Lynn, "North Jersey foreclosures haunt neighbors,"
The Record of Hackensack, NJ, May 13, 2012, available at
http://www.northjersey.com/news/bergen/bergen_news/1
51276055_North_Jersey_foreclosures_haunt_neighbors.ht
ml.

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