A Draft Solution to the Housing Crisis

The criticism leveled at the Obama administration's housing plan is that it does nothing to reduce the number of households that are (or will be) underwater (i.e. they owe more on their mortgage(s) then their houses are currently worth). It seems to me that there's an obvious reason that it doesn't do this. I can't see a lot of political support for reducing the principal owed by (especially subprime) many borrowers. I imagine there would be a lot of "Why should their mortgage principal be reduced because they paid too much for their house while mine stays the same because I (a) bought a smaller house and/or (b) put down a larger down payment so that even though my house has depreciated, I still have positive equity." And frankly, that's not a completely unreasonable opinion, right?

So what should we as a country do? What can we do? First, let's think about what happened during the housing bubble. Imagine there's a house with a true market value of $200,000 (i.e., the rent/buy ratio is around 1 at this price). Suppose it was bought 12 years ago at $200,000 by the Smiths. They lived in it for ten years and then sold it at the top of the market for $300,000 to the Johnsons. The Johnsons bought it with 5% down and a $285,000 mortgage. The mortgage was then packaged into a mortgage-backed security and sold to various investors.

The market has now corrected as the bubble has burst and the house is once again worth $200,000, leaving the Johnsons $85,000 under water. There's an $85,000 loss that has to be recognized by someone. It could be the Johnsons. The problem, of couse, is that most people who buy a $300,000 house don't have an extra $85,000 lying around. The only way they could end up paying the $85,000 is by paying off the mortgage, at least until the price got up to their mortgage balance. Another (market) option, is that the Johnsons walk away, mail the key to the bank who is then forced to foreclose and sell the house at a discount (probably significantly less than $200,000). The bond holders are then left holding the $85,000+ loss. We know they can swallow the loss because their asset simply has depreciated in value rather than creating a new liability (as it did for the Johnsons).

The problem with sticking the bond holders with the loss (as far as I understand it), is that most of these bond holders are large financial institutions. Reducing the value of their assets by a large amount (with lots of foreclosures) will put them under water (their assets will be less than their liabilities so that their capital will be negative or at least below the required amount for a bank to have) and they will be forced out of business or into receivership. If this happens to enough (or at least to large enough) banks, then the whole financial system seems likely to fail for the near future and we all lose. This is what happened in the Great Depression, combined with the fact that depositors lost their deposits when a bank closed.

So the losers are fairly clear: the Johnsons, the bond holders, and possibly everybody (represented here by the taxpayers).

The winners, in this case, are the Smiths, or are they? They received an extra $100,000 above the true market value when they sold their house. Of course, unless they were clever and decided to rent, they probably went and bought a $400,000 house that was really only worth $300,000 and have, therefore, lost that $100,000 they thought they made in the sale of their house.

When you look at it this way, you can see that there really are no winners here. Or if there are some, they are few and difficult to identify. For the most part our former selves were the winners and our current selves are the losers. The assets we thought we had have simply vanished because they were never truly there.

So what's the right policy? I have to agree with the critics of the Obama housing plan that point out that it doesn't do anything to solve the situation. The only way to truly solve the problem is to force the system to recognize all of the losses. The most fair way to do this is probably to write down ALL mortgages by however much real estate prices have fallen in that area (say by zip code) since the property was bought. This would involve trillions of dollars of loss for mortgage holders and MBS and derivative holders. However, for the most part, it's a loss that they've already recognized and may even be less. This would reduce foreclosures by getting everybody out from under water and would encourage investment in homes because people would no longer be facing losses. Reducing the principal and then allowing home owners to refinance at the current low rates would further help reduce foreclosures.

In our example, the Johnsons home depreciated by 1/3 from the time they bought it. Reducing their mortgage by 1/3 would drop it from $285,000 to $190,000. Their equity would have fallen from $15,000 to $10,000, but they would still have equity. Whoever owns the mortgage would face a loss of $95,000, but this is probably less than if the home went into foreclosure.

But what would happen for a "responsible" owner? Imagine the Miller family which bought a house for $250,000 with $50,000 down and a $200,000 mortgage. The house is now worth $220,000 meaning their equity has decreased from $50,000 to $30,000. In this case the value of their home has fallen by 12%. Reducing their mortgage principal by 12% would drop it to $176,000. Their equity would now be $44,000 (down $6,000 from the original but up $14,000 from current levels). The mortgage owner(s) would have seen its value drop $24,000.

There would be no direct cost to the taxpayer in this plan. The total cost to banks is hard for me to estimate. There's probably about $15 trillion worth of mortgage debt that would qualify. According to the Case-Shiller index, home prices are down almost 30% from their high, although they may have another 10-15 percentage points to go. That would mean that if everybody got their mortgage at the peak, the maximum write down of mortgage debt would be a little less than $5 trillion now or about $7 trillion if we wait for the bottom (we should probably only do this once). Of course, not everybody got their mortgage at the peak of the market, and regional markets have significant differences. The total write down would probably be between $3 and $5 trillion. It's a lot of money, but mortgage debt more than doubled between 2000 and 2007, so it's not a surprise.

Banks would probably fight this because it would reduce the value of the prime mortgages on their books that are unlikely to default. The question is, what would the net loss to banks be? They stand to gain something on subprime (and other) mortgages that will not now go into default. I would guess that the loss would be between $2 and $3 trillion. Unfortunately, that might put some of the larger banks under water (at least in terms of regulatory capital requirements). An injection of capital by the government for common shares would seem appropriate in this case as the government is forcing a reduction in the value of the banks assets.

Of course, that leaves the question of legality. This plan is probably not legal, and may even be unconstitutional. One option to force its acceptance would be to nationalize the major banks, take the write down, and then sell the banks to private investors. Hopefully, the banks would now be more attractive since the toxic assets currently on the books would have been mainly decontaminated.

Mortgage holders will be happy. Almost all will see an increase in their equity and a drop in the principal they owe on their mortgage. Renters will be pissed, so this would probably be a good time to eliminate the tax exemption for mortgage interest and give a one-time tax rebate to non-mortgage holders.

The plan should also help stabilize the real estate market by forcing home owners to recognize the fall in the value of their house. And it should help consumer spending by increasing the wealth of homeowners.