Obama Housing Rescue Whiffs on 'Underwater' Headaches

Plan to keep struggling borrowers in their homes overlooks a key issue, Wharton professor says.

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The Treasury Department proudly reported last month that it had extended more than 650,000 trial loan modifications through the end of October, putting it on track to hit its goal of reducing monthly payments for as many as 4 million struggling homeowners. Now the bad news: More than 1 in 4 borrowers who received a modified loan are already behind on payments, the Washington Post reported Saturday. What's behind this high redefault rate? With the unemployment rate at 10 percent, the rickety labor market is certainly one factor. But the epidemic of negative equity—which can tempt homeowners to simply walk away from their properties—is playing a key role as well. Here are four things you need to know about the development.

[See 10 Things to Know About Getting a Mortgage in 2010.]

1. One in four: The historic plunge in home values has dragged an alarming number of borrowers underwater, which means they owe more on their home loan than their property is worth. With home prices having dropped roughly 29 percent from their 2006 peaks, nearly 1 in every 4 American homes—or 10.7 million—was underwater in the third quarter, according to real estate information firm First American CoreLogic. And while the housing market has shown recent signs of stability, analysts project an increase in foreclosures to push home prices down even more. If that's the case, the number of underwater homeowners could rise still higher.

2. Strategic defaults: Negative equity is a serious headache for the housing market because it can make homeowners more willing to walk away from their homes—even when they can afford the mortgage payments. "Defaulting on their loan is a rational decision: While they forfeit their home, they rid themselves of a mortgage liability of even greater value," Alex Edmans, an assistant professor of finance at the Wharton School of the University of Pennsylvania, wrote in a white paper released Monday. "The source of the problem is the homeowner's balance sheet: Since he has negative equity in his home, it is not worth keeping it by paying the mortgage." This past summer, a team of three researchers found that 26 percent of defaults were strategic.

[Check out 6 Reasons Modified Loans Are Going Bad Again.]

3. Obama efforts: Traditionally, mortgage bankers have assumed that property owners would pay their home loans so long as they could afford to, Edmans says. Borrowers who go into default, therefore, must not have enough income. This philosophy is visible in the Obama administration's mortgage modification initiative, a $75 billion effort designed to bring home loan bills down to more affordable levels. In so doing, lenders and servicers can lower interest rates, extend terms, or forbear loan principal at no interest. The plan does not, however, require lenders to reduce a loan's outstanding balance. For that reason, the plan was effectively a bet that struggling homeowners would pay their mortgages if monthly payments were lowered, regardless of how much negative equity they had. Early reports on the program's performance suggest this thinking may have been wrongheaded. Edmans argues that government efforts like this have failed in part because they "are founded on the idea that default occurs because households have no choice due to insufficient income, and thus fail to address default that is a rational choice that depends on the homeowner's balance sheet."

[See Obama's Loan Modification Plan: 7 Things You Need to Know.]

4. Principal write-downs: Instead of simply lowering payments, Edmans believes policymakers should offer underwater borrowers incentives to stay in their homes. "Since default is a discretionary, rational choice decision made by the homeowner, an effective solution must provide incentives for the homeowner to choose not to default, rather than welfare to enable him to make payments," he said. The most effective incentive, says former Fannie Mae chief credit officer Ed Pinto, is writing down the mortgage principal for certain struggling homeowners. "What we need now more than we need anything is to de-lever the housing and finance industry, which has got too much debt on not enough housing value," Pinto said. "The problem with lowering the payment [without reducing the principal] is two years from now the roof starts leaking and the borrower wakes up and says, 'Do I really want to put another $5,000 into this house that I am $25,000 underwater on?' " Borrowers in that situation may choose to walk away, even though the government has already invested taxpayer money into the modification of their mortgages.

Lenders and services have been reluctant to write down principal for a number of reasons. For one, they don't want to eat the losses themselves. At the same time, principal write-downs are a tough sell politically. With the American public already fed up with bailouts, the idea of additional taxpayer cash to keep borrowers from walking away is likely to stir anger. Still, Pinto insists that principal write-downs—although unpleasant—are the most effective way to address the crisis. "We are on the hook for Fannie and Freddie and [the Federal Housing Administration], and so we might as well do it right," Pinto said. "If we do it right, we will save money."