Why Won't Treasury Fix Your Mortgage?

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Here's an idea: Instead of paying reluctant lenders to modify mortgages for borrowers in over their heads, maybe the Treasury should just step in, buy up the loans and fix them itself.

Wall Street Journal mortgage reporter James Hagerty relays this very idea from John Taylor of the National Community Reinvestment Coalition. The feds would buy the loans at a discount and rework them to reduce the principal that borrowers owe. The current Making Homes Affordable program doesn't push for this all-important step, though lenders can reduce principal on their own if they choose to.

This is the latest variation on the Home Owners' Loan Corp., the 1930s government agency that bailed a million Great Depression homeowners out of foreclosure. Back then, mortgages lasted only three to five years, and then had to be refinanced. Millions of borrowers who were underwater – that is, who owed more than their properties were worth – had nowhere to turn for a new mortgage when their old one expired. So the government stepped in and sold them new loans, much smaller than their old mortgages. The average HOLC loan was – brace yourselves - $3,028.
One out of five of these depression-era borrowers went into foreclosure anyway, because they couldn't or wouldn't pay; they also tended to have the priciest houses. (The feds ended up renting those out.) But most did very well and history has deemed the rescue a success.

The idea of a 21st century HOLC has been in the air since well before the Obama administration rolled out Making Home Affordable nearly a year ago. Then-Senator Hillary Clinton, economists Alan Blinder and Nouriel Roubini, and commentators liberal (Robert Kuttner), and conservative (Norman Ornstein) all endorsed the idea.

So why has the Obama administration stuck with its mortgage modification program, which from the start was clearly not the medicine most homeowners in trouble needed? Because while they care about you deeply, dear consumer/voter, their number-one concern is stabilizing the banking system and economy. Roubini laid out a game plan that could have helped both homeowners and banks. Instead, Treasury made the decision to focus on propping up the banks - at homeowners' expense. Along the way it has given billions and billions away where they weren't needed (hello, AIG).

So here's the paradox: banks are doing great, the economy is slowly recovering, but borrowers are still suffering. Contrast that to the Great Depression, when the economy ground to a halt as bank after bank failed. The economy was in such shambles there was nothing left to lose by having the government wipe the slate clean for homeowners by giving them brand-new mortgages.

Today, lenders don't hold on to mortgages. Pension funds, insurance companies, and other investors do, in the form of securities made up of bundled mortgages. These folks would take devastating losses if millions of borrowers got new mortgages, or even principal reductions. Yes, many are already hurting from all the foreclosures out there (right now, 14 percent of all mortgages are in default or foreclosure). But until the foreclosures happen, those losses loom somewhere in the theoretical future instead of settling in their portfolios. Cut principal on a mass scale, and the ratings on these mortgage-backed securities drop instantly, causing all kinds of mayhem for investors.

The Obama administration knows this. That's likely why it backed off from a proposal to allow bankruptcy judges to order "cramdowns," which would force lenders to reduce principal. Cramdowns would have helped only a small portion of troubled borrowers out there, those who ended up in bankruptcy court. John Taylor's idea would help millions and let the banks off the hook, but would pose that much more of a threat to investors in mortgage-backed securities.

Treasury Secretary Tim Geithner ought to take Taylor's proposal seriously and make those investors take a haircut on their overvalued securities. Don't be surprised if he doesn't.
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