Effectively Addressing the Foreclosure Problem

As we’ve discussed before, achieving real and effective Change requires stepping back and understanding the problem. If rabbits are eating up all the carrots in the garden, our first instinct is to grab for a gun. But killing rabbits may not be the answer. The problem is not the rabbits; the problem is the insecurity of the carrots. There are many possible solutions, and shooting rabbits may not be the best solution, or even a good solution. We’ll never know if we simply jump up, grab the shotgun, and head out the door.

The foreclosure and mortgage crisis is causing us serious problems. But what are those problems, and what is the best way to address them?

First, banks and other financial institutions that have Toxic Assets on their books simply aren’t trusted by other institutions, and have trouble getting credit themselves. Banks that can’t get credit can’t lend money. Banks that are asked to lend money to financial institutions at risk won’t do it. As a result, lending has dried up. The government has pumped money into many of these banks, but because the demands on the financial system fluctuate from place to place and from time to time, the system’s operation depends on frequent lending and paying back, even among banks that have money. And the banks aren’t willing to lend to each other. They now have nice piles of government cash, but that cash is going nowhere.

Second, without credit flowing, people willing to buy homes can’t get loans and can’t buy. Homeowners who need to sell drop their prices. All over the country, home values are falling, sometimes drastically, but almost always significantly.

Third, the credit crunch affects businesses that depend on short term loans to cover the costs of capital improvements, of payroll, and of other major expenditures. The result is that purchases aren’t made, profits are lost, businesses go into the red or even fail altogether, and employees are laid off. These employees lose their purchasing power, and can’t pay their mortgages. Foreclosure rates skyrocket.

The banks end up not only with “toxic” sub-prime mortgages, but with prime mortgages that have gone sour as well. When they foreclose, they’re stuck with managing properties that are dropping in value, don’t make up for the value of the original loans, and for which there are no buyers in any case.

The problem is not just about the property owners, and it is not just about the banks and their lending practices. The problem is about the complex system that unites them both. The solution to the problem must address the entire mix.

Here’s my proposal:
1) The government should create a new entity, which we can call the National Mortgage Bank (NMB). This entity will buy all of the Toxic Assets held by the banks — that is, all of the subprime mortgages, and all of the other mortgages that are heading for foreclosure.
2) To purchase these mortgages, the government will give the banks bonds guaranteed by the government. Why? Because the bonds will be trusted to retain their value where the mortgages are not.
3) The purchase price for the mortgages will be in line with the current value of the properties involved. This way the banks will not lose any money they haven’t already lost, and the government will not pay more than the actual value of the properties. The drain on the banks will cease, and they will no longer be viewed as risks by other financial institutions.
4) The NMB will then renegotiate all the mortgages it has bought. These renegotiated mortgages will be valued at the price the government paid for them, but the terms of the mortgages will be determined by the abilities of the borrowers to pay. One of the provisions of these new mortgages will be that if the borrower loses his or her employment and therefore the ability to make payments, there will be a temporary moratorium on making those payments (how long this moratorium might last will need to be determined — perhaps it should be for as long as unemployment benefits last, with the understanding that this should give the homeowner time to sell in the new, more stable economic environment that will follow the establishment of this policy).
5) When a homeowner does sell, he or she will pay off the mortgage, with the added proviso that one quarter of any money the homeowner makes above the value set on the renegotiated mortgage will be given to the government. Today this seems like it will give the government nothing, but as stability returns to the economy over the next few years, housing values will rebound, and by the time a long-term homeowner sells, the difference between the house’s value today and its value on the sale date could be considerable.

Let’s look at how this works in a brief example. First, a bank buys a mortgage for $1 million dollars. Then the economy falls apart, at the same time that the house payments jump up in size. The value of the home drops to $750,000, and the homeowner suddenly finds herself unable to make the payments. The bank forecloses. The one-time homeowner is now out on the street. The house stands there, empty, while no one buys. The bank pays for maintenance on the home to keep it from losing more value. Someone would like to buy the home for $600,000, and the bank is willing to sell, but not willing to write a loan, and no other bank is ready to write the loan either. So there’s no sale. What is the value of this property to the bank? There is an asset on the books, but it can’t be turned into cash.

But what if the NMB stepped in before the foreclosure? The NMB gives the bank $750,000 in government bonds, which the bank can trade or sell. This immediately gives the bank liquidity. The NMB then renegotiates the loan with the homeowner, who can stay in the home but with much reduced payments. After a year, the economy begins to improve. After three years, the value of the house has risen to $800,000, and the homeowner has obtained a better job. After eight years, the house value is back up to $ 1 million, and the homeowner decides to sell. The government has received the renegotiated house payments regularly, and is now paid the remaining principal on the mortgage, along with an additional $62,500, the government’s 25% benefit for performing this service. The homeowner who would have broken even at $1 million if she had been able to maintain her payments and not risked foreclosure, now finds herself $187,500 to the good.

Who loses? The bank. But the bank loses much less than it would otherwise, and is able to get back to the business of banking instead of simply being a money-losing real estate maintenance firm.

Who gains? The person who didn’t lose her house, and was able to survive through tough times thanks to the help of her fellow citizens.

And what about those citizens? What about their taxpayer dollars? Well, they didn’t actually lose much of anything, in the long run. The NMB merely held the assets in good condition for a longer period of time than a bank could, with less pain to the homeowners, and with a decidedly beneficial effect for the economy.

What about that $62,500? Well, that helps pay some of the interest on those bonds given to the banks, and it helps to defray some of the cost of operating the NMB. Is the government going to come out with a profit? Maybe not directly, but if this kind of approach to the mortgage crisis can help stabilize the economy and start getting it turned around, then everyone, including the government, benefits indirectly.

The taxpayers don’t lose on this one, even if they put out some funding to start the process moving.