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Negative Equity is the Problem

Negative equity is where a person’s mortgage balance is higher than the value of home.  This has serious implications for the person and the rest of the housing market.  But nothing has been done to address this problem - including the President’s mortgage modification program.

Right now, the biggest problem is negative equity.  It is causing people to strategically default or simply walk away from their homes and mortgages because the mortgage is so far underwater (negative equity).  And it is causing a problem for those who want to sell their homes but can’t get a high enough offer to pay off mortgages and provide a little down payment on another home. 

The foreclosure problem is not going away - in October there were another 332,292 foreclosures.  This is having a huge impact on the entire housing market because it is causing downward pressure on home prices which exacerbates the negative equity problem which then feeds back into the foreclosure problem (via strategic defaults).  Again, policy makers in Washington have done nothing to address this problem.

Earlier this year the Obama Administration launched a plan to help homeowners avoid foreclosure by providing $75 billion of taxpayer money to banks and mortgage servicers.  This plan was flawed in the beginning because it failed to address a huge conflict of interest problem that mortgage servicers had.  And now we are seeing the results of this failed approach:

As many as 3.4 million homes are expected to enter foreclosure by year’s end, with some experts estimating that next year will be even worse. As of Sept. 1, less than two percent of homeowners who received a temporary modification under Obama’s plan ended up with a permanent fix. And so far, the plan has already cost taxpayers about $27 billion.

Only five of the 1,711 permanent modifications as of Sept. 1 involved a principal reduction—in fact, most homeowners with a permanent fix ended up owing even more on their mortgage than they did before the modification.

The better approach from the beginning would have been to focus directly on the problem - negative equity and to do so would require debt forgiveness or reduction in the principal of the mortgage.  But no, that would have required that financial conglomerates experience some pain and policy makers don’t want to upset financial conglomerates.  This plan wasted money by not focusing on the problem.

Others are saying the same thing:

John D. Geanakoplos, a Yale Professor of Economics:

“I think the Obama administration has made a big mistake. The administration’s plan went about as badly as I foresaw, possibly even worse,” he says. “Things have been awful. They’ve barely modified any loans, and those they have haven’t done any good.”

“I don’t fathom the logic of their plan,” Geanakoplos says, looking back. “I can’t figure out who it’s going to help.”

New York Times Editorial:

To help people with negative equity, the subsidies in the Obama plan should be redeployed so that they are used to modify loans by reducing the principal balance. That would restore equity in addition to lowering payments, and in the process, reduce the risk of re-default.

This negative equity problem will not go away anytime soon and the entire situation is made worse by climbing unemployment.  We have to come up with a better plan than the one that is currently only helping financial conglomerates.  Mr. Geanakoplos and colleague Susan Koniak did propose one:

a government-formed, taxpayer-funded plan that would focus on reducing principal for credit-impaired homeowners who were underwater in their mortgages. Total cost to the taxpayer: About 3 to 5 billion dollars over three years.

Here’s how it would work:

The program would be limited at first to subprime and other nonprime borrowers who were current on their mortgages because a) you don’t want to reward homeowners who have fallen behind on their payments, thus risking a situation where homeowners are incented to fall behind and b) homeowners with good credit typically value their high credit scores, thus are more likely to make regular payments and not become delinquent.

The plan would be administered by a staff of community bankers, who would be hired from the private sector. That’s where the cost comes into play. These folks, who would be experienced in dealing with home mortgages and loan modifications, would be the ones looking at individual mortgages and trying to determine the best course of action. Under the administration’s plan, mortgage servicers do the modifications. The results haven’t been stellar.

A key to the plan was that the reduced principal would be less than the value of the house - so the homeowners would have equity again - but still greater than the note-holder could get simply by foreclosing. For example, suppose a couple took out a $280,000 mortgage when they bought their home, but the home’s value dropped to $200,000. “Bondholders today anticipate making as little as $70,000 on a foreclosed home like that in our example,” Geanakoplos and Koniak wrote, because foreclosed homes typically sell for a steep discount relative to other for-sale homes. So the principal would be reduced to somewhere between $200,000 and $70,000.

Again, why not address the problem in the housing market directly?  Yes, it will require some pain and skin from the financial conglomerates but so what they caused this mess in the first place and have not been held accountable for it.  Now, is the time for accountability and for some hair cuts for financial conglomerates.

Good luck.