Next up for feds, tonic for hurting homeowners

Job no. 1 for the Federal Reserve Board and the Department of the Treasury was to stabilize the capital markets.
NOV 23, 2008
By  MFXFeeder
Job no. 1 for the Federal Reserve Board and the Department of the Treasury was to stabilize the capital markets. That seems to have been accomplished. Job No. 2 is to stabilize the housing markets. Unfortunately, no one has yet devised a workable plan to help struggling homeowners without violating the rights of mortgage-backed-securities owners or provide incentives for more homeowners to walk away from homes where the current values are less than the mortgages. Devising such a plan is critical to providing a foundation for an economic recovery, for as long as home prices continue to fall and owners continue to default on their mortgages, the value of mortgage-backed securities will continue to decline. That means banks that own such securities will see their capital base under threat and will be reluctant to lend. In addition, homeowners who see the value of their homes declining will continue to be reluctant to borrow to buy cars and other big-ticket items. Companies, seeing that consumers are not spending, will continue to be reluctant to borrow and invest. The result will be continued economic weakness and a prolonged recession. The first plan to be proposed by the Treasury and the Federal Reserve to stabilize the housing market, in which the Treasury would buy illiquid mortgage assets from the banks through a reverse-auction process, fell apart when the Treasury realized that price discovery through the auction process would take too long to implement. The Treasury instead decided to provide capital to the banks directly by buying preferred stock, expecting that improving the banks' capital positions quickly would encourage more lending. The plan seems to have stabilized the banks and the capital markets, but consumer and business confidence remains low, in part because home prices continue to decline. Hence the urgent need to find a way to put a floor under home prices by reducing defaults and foreclosures, and bolster housing. There are several possible approaches, but each has flaws. The government could mandate that lenders write down the principal amounts of mortgages of homeowners in danger of foreclosure. There are at least two problems with this approach. First, it would breach the rights of investors who bought the mortgage-backed securities in which the mortgages resided. This would seem to amount to the illegal taking of private property and would surely face a challenge in the courts. Some banks that have voluntarily modified mortgages in this way are already being challenged by holders of mortgage-backed securities. Second, it might encourage homeowners whose mortgages are underwater, but who can afford the mortgage payments, to threaten to default to get similar treatment, worsening rather than helping the decline in home prices. A second approach might be for the government to mandate that banks reduce the interest payments on mortgages for homeowners threatened with foreclosure or stretch out the repayment period. But this would run into the same problems as the first approach. In addition, lenders would no doubt demand higher interest rates for mortgages in the future to offset the risk of a government-mandated interest rate cut. Sheila Bair, chairman of the Federal Deposit Insurance Corp., has proposed that the government encourage lenders to reduce the burden of principal and interest payments of homeowners in trouble by offering to reimburse the lenders for half of any losses on any modified loans that default. It's doubtful if this would be sufficient incentive to get many lenders to participate, and it still leaves the issue of dissenting investors. Perhaps new tax incentives could induce such investors to participate voluntarily, avoiding the legal issues arising from a mandate. But the modifications to mortgages must be carefully designed and targeted to avoid encouraging even more homeowners to default. A cleaner solution would be for the government to buy foreclosed homes and knock them down, thereby reducing supply and firming prices. The government has acted similarly in the past, buying up and destroying surplus crops to support farm prices. But with so many people without homes, destroying perfectly good housing would cause an outcry no politician could withstand. Still, time is running out. The Treasury, the Federal Reserve and Congress must quickly decide on a housing support program and get it into place. The longer they delay, the more severe the recession will be, and the slower the recovery.

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