Will common sense prevail?

By January 6, 2010Housing Market

Nick Timiraos over at the Wall Street Journal called my attention to a new study out from the New York Fed. It essentially says that loan modifications are less likely to default if they include a principal balance reduction. While my initial reaction was simply “Duh”, I’m glad to see this minor acknowledgement of the real issue – negative equity – at the federal level.

I’ve known for a long time that with the exception of the Five D’s (Death, Divorce, Drugs, Disease and Denial), foreclosure is the result of negative equity which leaves the homeowner trapped in a prison of debt unable to sell or refinance (with the possible exception of a short sale). Negative equity is so obviously the root cause of foreclosure it is hard for me to believe that the Fed had to commission a study to find out that loan mods which fail to address this core issue are less likely to succeed.

The root problem with the current Making Home Affordable loan modification programs, and the general idea that negative equity does not have to be addressed in order to avert this crisis can be traced back to a study by the Boston Fed. That study  essentially concluded that negative equity was not enough in and of itself to result in default and that job loss or some form of payment shock, like payment resets, was also required. They looked at Massachusetts foreclosures from the 1990’s to come to this conclusion. I instantly had issues with the study, given that the 90’s downturn was due to a recession rather than a massive bubble, because home prices dropped far less then vs. now, and a much smaller percentage of the population was affected. How anyone could think that period was indicative of what we could expect this time around was a clear example to me of how economists regularly get lost by failing to take into account basic common sense. You’d think they’d get that after nearly universally missing the housing and credit bubbles which got us here in the first place. I wasn’t the only one who thought this study was off base and I thought the folks over at the Kellogg School addressed its short comings nicely in their study on Strategic Default.

Now perhaps, with this latest study, the Fed is finally getting a clue and coming to the realization that addressing negative equity will ultimately be a required part of getting back to a healthy housing market. And if so, what’s next? Nick Timiraos noted today that Barney Frank doesn’t think we can force lenders to lower principal balances. But perhaps the quiet move on Christmas Eve by the Treasury to remove the cap on funding to Fannie Mae and Freddie Mac is an effort to get this done through the backdoor… at taxpayer expense.

No question in my mind that we have to address the negative equity problem. The only question now is how. Will the powers that be try to sneak it onto the back of taxpayers, will they force lenders to eat the losses potentially pushing our financial system back to the brink of collapse, will there be a national discussion and administrative leadership on how to best deal with the excess $4 Trillion in housing debt, or will they continue to extend and pretend with foreclosures trickling out for years to come? My money remains on the last choice, but I’ll be watching closely.

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  • Becky says:

    Interesting – I saw this study of the New York Fed earlier today – just a few horus ago, in fact.

    That on the heels of an analysis of a central valley loan mod wherein the borrower will end up paying over 900K for a town house worth only 200K by current market values – a whopping 560K more than a 30 year fixed loan at current rates for the current market value… Why? The principal balance on the “new loan” for th mod is 419K – up a nice 38K from the initial loan balance thanks to fees and etc…

    The real problem, it seems to me is that no one wants to take the losses – and so long as the govt thinks the borrowers can manage it in loan mods, they’ll keep trying that and failing – and since the banks control the govt it looks as though the taxpayer will end up paying for the losses – which is also a huge malfeasance – since the taxpayers didn’t write the bad loans that created the mess.

    I noticed you also brought up the new HUD rules on Short Sales which just add more difficulty to the issue – and we are already seeing homeowners being denied short sales when they fail the loan mod process – but the new HAFA rules which are supposed to get the lenders to agree to shorts or DILS upon a failed loan mod application don’t go into effect until April. Hard to know what to tell a homeowner to do…

    Here’s the HAFA info in case you haven’t seen it:

    HAMP Update

    HAFA – New Program Offers Borrowers Foreclosure Alternatives

    Introduction of Home Affordable Foreclosure Alternatives – Short Sale and Deed-in-Lieu of Foreclosure


    Supplemental Directive 09-09 provides guidance to servicers on the Home Affordable Foreclosure Alternatives Program (HAFA) and includes the general terms and conditions, evaluation process, documentation, and reporting requirements. As part of the Home Affordable Modification Program (HAMP), HAFA provides financial incentives to servicers and borrowers who utilize a short sale or a deed-in-lieu (DIL) to avoid foreclosure on a HAMP-eligible loan.

    Foreclosure Alternatives

    The HAFA program simplifies and streamlines the use of short sale and DIL options by incorporating the following unique features:

    * Complements HAMP by providing viable alternatives for borrowers who are HAMP eligible.
    * Utilizes borrower financial and hardship information collected in conjunction with HAMP, eliminating the need for additional eligibility analysis.
    * Allows the borrower to receive pre-approved short sale terms prior to the property listing.
    * Prohibits the servicer from requiring, as a condition of approving the short sale, a reduction in the real estate commission agreed upon in the listing agreement.
    * Requires that borrowers be fully released from future liability for the debt.
    * Provides financial incentives to borrowers, servicers, and investors.

    Timing & Eligibility

    Servicers – Supplemental Directive 09-09 is effective April 5, 2010, but participating servicers may elect to implement HAFA prior to April 5, 2010, in accordance with the Supplemental Directive. In order to participate in HAFA, a servicer must have executed a HAMP Servicer Participation Agreement (SPA) by December 31, 2009. (The HAMP SPA is available for review on HMPadmin.com.)

    Borrowers – Servicers must consider a HAMP-eligible borrower for HAFA in accordance with their policies within 30 calendar days of the date the borrower:

    * Does not qualify for a HAMP Trial Period Plan,
    * Does not successfully complete a HAMP Trial Period Plan,
    * Is delinquent on a HAMP modification by missing at least two consecutive payments, or
    * Requests a short sale or DIL.

    Note: A borrower must be considered for a HAMP modification and other retention programs offered by the servicer prior to being considered for HAFA.


    I’m afraid common sense went out the window long before we got here, however – and I don’t see any sign of it returning any time soon – I actually got an image in my head to day of a great cartoon – Big Pharm, Big Banks, Big Ag, Big Oil all holding the strings to the marionette of our President and him holding out a handful of change saying “Oh, yeah, here’s your change!”

  • Skeptic says:

    Negative equity is obviously a problem. But principal write downs is perhaps the worst thing that could ever happen and will certainly bankrupt the entire economy. Why?

    First, you have those who lost their jobs and can’t pay. Well, if they default what good is a principal write down now, they can’t pay.

    Second, you have a group that can’t afford a reset, but they can continue to afford to pay and are honorable about paying. Why give them a gift. They will pay, reduce the rate and extend the term. Sure they are locked in, but they keep the money flowing.

    Finally, we have the strategic defaulters. I know of at least 3 myself. They can all afford their mortgages, but why should they continue to throw their money away? So they defaulted and eventually lost their homes. If you do principal write downs for this group, you will essentially open a floodgate for principal write downs for everyone. This will bankrupt the banks and the economy.

    My solution is simple for group 3. Tax the loss on a foreclosure. Tax the income on free rent. This will eliminate a huge incentive for group 3 to default–as now you’ve reduced their free rent benefit by 50%. Alternatively, the feds and the state will get a lot more tax revenue if they choose to default. So you keep group 3 paying or they pay the government, you keep group 2 going with the modification and unfortunately you foreclose group 1–but in a different time and different day you would do this anyway. Without group 2 and 3 in the fray, this group could get more money for their homes.

    But a write down for group 3–whether by the government or the privately owned banks is an invitation for everyone with a mortgage to default.

    • Sean O'Toole says:

      I agree that moral hazard needs to be taken into account. Also note you forgot the most powerful reason for not offering principal reductions… those that don’t need them will default to get them.

      But what is the alternative? I get that you think we should bring back debtors prison and force people to live with an American Dream turned nightmare, but that really won’t help.

      Our economy is no longer manufacturing based. It is based on selling each other services, and with 30% of the country underwater in their homes it should be equally obvious that our economy will not get better until we solve this problem, no matter what you hear on CNBC.

      I tried to find a balance when I proposed a solution here: http://www.foreclosuretruth.com/blog/sean/part-7-how-wipe-out-4-trillion-excess-mortgage-debt/. It even includes a variation on the tax hammer you suggest above to encourage the right behavior.

      • Skeptic says:


        I think we are somewhat aligned on the strategy that the strategic defaulters should be paying Uncle Sam for the mess they are creating. I thought my group 3 strategic defaulters were pretty much the same group as your–will intentionally default to get the reduction.

        Why am I so concerned with this? Because I own a second home that is underwater. I’m a good credit risk with a fair amount of money. I can afford to buy cars and vacation for cash. I have my principal house that I’m happy with and already set in a low mortgage. I don’t need credit.

        Its not worth it to me to default on the second home, hurt my credit and lose the house, so I keep paying. But if you tell me, go ahead and default and I can get a 100K principal reduction, I’m defaulting. I imagine there are a ton of others who will do the same and this will destroy our economy. You seem to be a pretty well respected authority on this mess and I see you quoted in a number of articles. I would hope you can see the danger of widespread principal reductions and don’t disregard this. The single best thing to do is the tax hammer you proposed to keep group 3 at bay. Let the foreclosures go through (versus principal reductions) for group 1, and yes imprison group 2–remember group 2 can get out of jail too, they just need to pay a hefty tax bill too.

      • Skeptic says:


        What more question. Based upon your analysis of the market and the type of meaningful principal reduction would be needed. What is your estimate as to the cost of this utter fiasco?

      • Sean O'Toole says:

        $4 Trillion. Had the Fed put the trillions they spent on bailing out banks and temporarily propping up markets into bailing out homeowners (which would have also bailed out banks), we’d be a lot closer to done right now.

        I arrived at $4T by looking at the increase in housing debt from 2000 to today, and comparing to where it should have grown over that period based on population growth and wage inflation.

  • Becky says:

    None of this takes into account the cause of this mess and how it all happened. The banks are the ones who flooded the market with easy money and liar loans. Taking the position that the homeowners created the problem and saying it will wreck the economy if they don’t fix it is fear based moralizing to defend an ‘economy’ that is already well beyond ruined, broken, destroyed.

    Thinking we can get the people of this nation to carry the debt load created by this credit bubble to “fix” it – makes no sense at all to me. First of all they can’t afford it even if you want them to, and second of all no one will, over the long term do things that are against their own best interest. It is counter to right thinking. Asking them to do so to fix something that is already well beyond broken is a losing proposition – just my opinion. I’ll have to go read your ideas for a solution Sean and see if they are different that this.

    When do we address that this is at its root the result of a control fraud perpetrated with knowledge and forethought by the lenders? Built on short term profits, a need for upper overpaid management to meet their bonus marks and no regard for the fact that a control fraud by its nature destroys all players. We are already there. Where is the logic to apply the pricing based on median incomes? Where is the logic to apply sound financial principles?

    You cannot fix this by doing anything that is punitive to the people – not by increasing tax burdens to the homeowners – not by paying the banks off with tax money for all their self imposed losses.

    That over ballooned debt sitting on all those mortgages is ficticious – it’s based on false values created directly by inflated money supplies (credit) which had no business being flooded into the market int he first place.

    • Sean O'Toole says:

      While I don’t completely disagree, I think we create all kinds of moral hazard if we simply give everyone a free ride. Plenty of folks used their home like an ATM – and while the banks should have known better, letting those folks keep the boats, hummers and the big house hardly sends the right message either. Plus I think writing that check would bankrupt either our financial system (if they bore the loss), our nation (if taxpayers bore the loss), or both.

  • Long Copy Sellseven Mortgages You know what I was told when I sent my first ever mailing to the printer ‘Who will read all that stuff You’ve got way too much copy here. no one’s gonna read it all. You should trim it down to one page. no one has time nowadays to read all that!” ….