In a speech to the New Jersey Bankers Association Economic Forum in Newark, New York Fed President William Dudley called for Fannie Mae and Freddie Mac to enact a form of principal writedowns on mortgages in order to help the housing market recover.
We’ve discussed the problems in the housing sector ad nauseum, but it they are worth briefly recapping. Home prices are down by about a third on average since 2006. There are 1.5 million mortgage that are at least 90 days delinquent, and another 2 million in some stage of foreclosure. There is a massive overhang of housing supply both on the market and in shadow inventory, and there is a dearth of demand for housing due to unemployment, economic uncertainty, and lack of household formation. This imbalance in supply and demand is still causing home prices to fall. Additionally, nearly 11 million homes with mortgages have negative equity, which accounts for about 22 percent of all homes with mortgages. There is about $700 billion worth of negative equity in the housing market. Dudley says that
“Persistent weakness in housing is particularly problematic because it acts as a drag on spending and job creation in an environment in which such weakness can not be easily offest by other policy adjustments. Housing policy should seek to break adverse feedback loops [Dudley is referring to the way that price declines lead to foreclosure, which in turn drives more price declines, which leads to more foreclosure], promote more economically efficient outcomes in housing, and support growth”.
In order to help the housing market, Dudley calls for “improved access to mortgage credit, reduced obstacles to refinancing, lessening the flow of homes into foreclosure through bridge financing and accelerated principal reduction, and facilitating the absorption of REO back into use as owner- or renter- housing”. The proposals for improving access to credit and turning REO into rentals are fairly straight forward. More interesting to me is the proposal for what Dudley calls “earned principal reduction”. Dudley proposes:
“I believe we should also develop a program for earned principal reduction for borrowers who are underwater but keep on making their mortgage payments. Such a program would strengthen the incentives for mortgage holders who are underwater to continue to stay current on their loans, and reduce the likely number of defaults and REO sales.
One option developed by my staff is for Fannie Mae and Freddie Mac to give underwater borrowers on loans that they have guaranteed the right to pay off the loan at below par in the future under certain circumstances, including that the borrowers have continued to make timely payments.
The borrower would be protected from further declines in home prices, but in return would give up a portion of any upside from future capital gains on the home via a shared appreciation agreement”.
Dudley says that a proposal such as this would be in the interest of the taxpayers, homeowners, and Fannie and Freddie. Many resist the idea of principal reductions because of the “moral hazard” involved*, but Dudley dismisses this argument, noting that many of the loans that are now going bad are prime loans made on properties that purchased at the peak of the market:
“The problem was that these purchases occurred near the peak in the market and now many of the buyers have suffered and adverse life shock such as unemployment or illness. This isn’t a moral hazard issue, this is just the bad luck associated with the timing of the purchase and an exceptionally weak jobs market. Punishing such misfortune accomplishes little”.
I am in favor of principal reductions because I see it as being the most efficient way to deal with the $700 billion worth of negative equity that plagues the housing market. Foreclosure is destructive and grossly inefficient. Short sales are difficult to complete and are few and far between. Mortgage cramdowns through bankruptcy are no longer available due to the gutting of bankruptcy laws. Growing our way out of this mess seems like a pipe dream. The fact of the matter is that until we deal with the huge negative equity problem that faces us, the housing market will struggle and the broader economy will not recover.
*I particularly bristle at the moral hazard argument, because it is often presented by people who were in favor of the bank bailouts, which one could argue caused moral hazard at a far greater scale than principal reductions. What is good for the goose is good for the gander. We either assist everyone, or assist nobody, but I don’t think we should selectively bail out the banks for their foolishness whilst punishing homeowners, the majority of whom were more victims of misfortune than willful risk-taking behavior. Not everyone deserves a principal reduction, but in many instances principal reduction would be the best way to help the housing market and our economy.