January 6, 2012 by 3 Comments

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.





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  • shiloinns@aol.com' Mark says:

    Here is the logical solution to fix the housing market & the economy:The “One – Year Mortgage Holiday” 9 Point Economic Recovery & Jobs Plan, as fully detailed at http://www.saveoureconomy.com is the only legitimate economic stimulus plan designed to actually solve the current housing, credit, banking, financial crises, that will jump start our economy, create millions of new jobs, stimulate growth and generate long term economic prosperity.

    The #1 key element of the plan, the “silver bullet”, is an ingenious “One – Year Mortgage Holiday” for every home owner & business in America, so that for 12 months, you do not have to make a monthly mortgage payment. All Renters of apartments, retail & office space will also get a 38% rebate on their rent. Consequently Main Street, that has already spent & wasted Trillions bailing out Wall Street and received nothing in return, since credit markets are still frozen, foreclosures, unemployment and bankruptcies are still rising, would then be able to have a well deserved one year “Time Out”, from having to make a mortgage payment. So a 25 year mortgage simply becomes a 26 year mortgage. All mortgage bank lenders, would still be paid a monthly average interest rate of 6% on all mortgage debt in the country. This would allow consumers, all home owners, renters and businesses to decide for themselves how best to spend, save & invest their own money each month, that would inject approximately $80 billion monthly back into the economy.

  • kevinklare@yahoo.com' Kevin says:

    Dudley’s remarks and recommendation are infuriating.

    “The problem was that these purchases occurred near the peak in the market”

    No, the problem was that a housing bubble existed, and it was fueled by YOUR agency.

    How could this guy recommend policies which will rob taxpayers by hundreds of billions of $$$, thereby encouraging MORE people engage in reckless financial behavior?

    The FRB helped to create bubble, yet continually denied its existence. Any honest or intellectual individual could see that it was a bubble. I saw it, most economists saw it, and my barber saw it.

    Then there is the insistence that mortgage debt is a problem, and ought reduced (on the backs of taxpaying non-debters) while continuing their contradictory policy of artificially-low target rates… low to ENCOURAGE higher leverage, higher loan amounts, and higher private debts.

    “and now many of the buyers have suffered and adverse life shock such as unemployment or illness”

    Many people have suffered those things, and there are safety nets them. A near-trillion-dollar bailout for the predominantly-wealthier class who participated (and perpetuated) this bubble is the MOST immoral and LEAST economically-defensive policy which could even be considered. Those “adverse” events such as illnesses have NOTHING to do with whether they are home-debtors or not. This b.s. is insulting.

    “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”

    No, timing is irrelevant, it is 100% a moral(and moral-hazard)issue, and “bad luck” is a euphemism describing reckless speculative gambling.

    Was losing money in the tech bubble bad timing? Were investors “suffering” or in need of a bailout?

    People had a choice – proven by the one-third of the country who were renting when ANYONE could buy ANY house. To make that leap was 100% your fault (the FRB and your lender are at fault for your ability to do this), and taxpayers have already subsidized enough of this stupidity.

    “Punishing such misfortune accomplishes little”

    Punishment? How stupid does this jerk think people are? There is NO punishment. I would take a 300-point his on my credit score to eliminate a half million in debts ANY day of the week. Fact is, the lack of punishment is why a third of foreclosures are strategic default. People who gambled and drove up the prices of RE and can still pay are choosing not to.

    The bubble was perpetuated by a sub-populace of willing participants. They either did not research the most expensive purchase in their life, or were gambling with others’ money due to pure greed. Either way, their ability to walk away and not pay back the money creates a huge moral hazard. Sweetening the deal with de-facto six-figure reward money is disgusting.

    If there were ever a reason to outright oppose the existence of the FRB, it is this soulless, gutless, policy wonk Mr. Dudley. When can we stop this revolving door from Goldman Sachs into our govt? Every action they take is another blood letting on the American people and our economy.

  • kimberliwilson@aol.com' Kim Wilson says:

    Why doesn’t Fannie and Freddie apply a formula like child support? The formula could incorporat­e all 4 scenario’s­. Homeowner (1) has a job (2) Doesn’t have a job (3) Can afford to stay if price reduced to fair market value (4) Can’t afford to stay no matter what. Can afford to stay with reduction to market value = Principle Reduction. Temporary unemployme­nt ??? = 6 month forbearanc­e and already agree to cash for key amount at the end of 6 months if can’t bring payments current. Or if in the worst hit areas trade condo for keys after 6 months. Instead of cash give an already repo’ed condo valued at $50,000 for example, for free. This would work in states like Nev. and Fl.the worst hit states in foreclosur­es. Realty Trac reported in Jan 2012 in Florida it took an average of 806 days to complete a foreclosur­e in Florida. If you would cram a loan down $50,000 if they had a job. Why wouldn’t you trade a 50,000 condo that has already been repo’ed if they can’t make the payment to eliminate the the 806 day wait, it cost the same. They get one property on the market right away and remove one from their inventory. No brainer!

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