Before, I criticize it, I will say that the plan announced today is better than anything we have seen up to this point. It is the first plan that does not require a borrower to be 60 days behind in their payments to get relief. That's a big step in the right direction.
However, I have concerns about the effectiveness and fairness of the most important part of the plan. This part provides incentives to rework mortgages so that they are no more than 31% of the borrowers incomes.
Consider three homeowners. Each bought a house in the Valley in 2006 for $400,000 and the value has decreased to $200,000.
1. Income of $50,000 per year, and got 100% financing and a sub-prime, no-doc, adjustable rate mortgage. This person is almost certain to default if not already.
2. Income of $75,000 per year and put 10% down, and has a $360,000 mortgage. Their initial $40,000 down payment is gone, and they are deep underwater. They can’t refinance, are deep underwater and have moderate default risk depending on their loan.
3. Income of $100,000 per year and put 20% down, traditional mortgage. Their initial $80,000 down payment is gone for good, they are deep underwater on their mortgage ($120,000), but can afford their monthly payment. These are responsible buyers who could have bought a lot more house in the 2006 lending environment, but stuck to a traditional, conservative loan.
How is each family treated by the Obama foreclosure plan.
Family #1. Their mortgage is adjusted down to a monthly payment of 31% of their income or $1291 per month. Taxpayers subsidize an interest rate of around 1% (assuming a 30 year mortgage). [Update 2/19: It appears the Treasury has announced it won't subsidize mortgages below 2%, so this family will be ineligible for the program unless they can convince their lender to write down the principal by $50,000, as 31% of their income would pay a 2% mortgage on a $350,000 balance.]
Family #2. Their mortgage is adjusted down to a monthly payment of 31% of their income which is $1937.50 per month. They get a lightly subsidized taxpayer interest rate of around 5% (assuming they are in a 30 year fixed). They pay $7800 more per year than family #1, and over $1,000 per month more in interest. They are still deeply underwater with little chance of coming out, and have already lost their $40,000 down payment.
Family #3. Their current monthly payment is less than 31% of their income, because they could afford it in the first place. They can’t refinance to a lower interest rate (even under the new plan), because they are still deeply underwater despite putting 20% down. Their $80,000 down payment is gone. They have lost the most, but get no help, because they are considered the least likely to default.
The benefit of this policy is a short-run decrease in foreclosures. However, in the long-run all three families are in a serious negative equity situation that is unlikely to change for a decade or more. Thus, they will eventually default or short-sale if they move. Family #3 hasn’t even seen a reduction in monthly payments and can probably rent a comparable house for less than their mortgage. Family #3 has a strong incentive to “walk away”, and this policy is betting a lot on the hope that their past responsiblity demonstrates that they won't. Not much has been done to mitigate the long-run risk of foreclosure for any case, as the payments for #1 and #2 will start increasing again after 5 years and they will all still have negative equity.
Assuming this policy postpones defaults for a few years, taxpayers are on the hook for about $11,000 in incentives for the first 2 cases of reworked mortgages, and over $4,000 per year in interest subsidies for cases 1 and 2. Over 5 years (assuming no defaults), the cost to taxpayers is around $44,000 to help the first 2 cases stay in their homes longer. Eventually, we will still bear a significant cost from foreclosure too.
By basing the monthly payment on income rather than the value of the home, the program is a lot like welfare with a similar trap. People are “taxed” in terms of giving up their subsidy for earning more income. Family #3 or #2 could choose to earn less (quit a part-time job, perhaps have a 2nd earner stay home), and have a large amount of the lost income replaced by a big mortgage subsidy.
We are still awaiting some details on the Obama plan, so it could turn out to be somewhat better than I describe. However, I still believe “shared appreciation mortgages” are the best approach. These are discussed in some previous posts.