There is a desire to find that one size fits all, “get us out of the housing recession” program that is a win-win for everyone. Several supporters argue that universal mortgage principal reduction is that fix. By “universal”, I mean to identify proposals offering all (or most) borrowers in negative equity (even if they are not in default) forgiveness of all (or most) of their negative equity. Such plans should be distinguished from the way principal reduction is used today as one of many possible remedial options for borrowers who are in default (albeit an option that is not widely utilized).
As an example of such calls, take Martin Feldstein’s recent proposal in the New York Times proposing that banks and the government split the cost of writing all mortgages down to 110% of the value of the home. There’s also the Win-Win proposal being put forth by an independent coalition of community groups that proposes that banks write down the entirety of the negative equity debt themselves.
Negative equity is and will continue to be a major factor determining housing dynamics in the next several years (and not in a good way) so I understand the impulse to just make it go away. Thus, I greet each new proposal dealing with negative equity with a hopeful eye but, invariably, I find them each unable to overcome some very thorny issues once examined.
First, there’s an issue of efficiency. Zillow estimates that about 15 million single-family homeowners are underwater on their mortgages and the total amount of negative equity is greater than $750 billion. But the vast majority of these homeowners are not going to default on their mortgages. Negative equity makes foreclosure more likely if there’s a disruption in income, but most of these borrowers will not experience such an event. So most of the money spent on universal principal reduction ends up with people who weren’t ever going to default on their mortgages. It’s another policy along the lines of the federal home buyer tax credits that paid up to $8,000 to buyers who, for the most part, were going to buy a home in the near-term even without the tax credit.
Second, there’s the issue of who pays for this policy. If we are to pay off $750 billion in mortgage debt for Americans, who precisely should pick up the tab? Taxpayers? The debt super committee can’t agree on how to come up with $1.5 trillion in spending cuts or new revenue but we’re willing to increase the size of the task by fifty percent? How about the investors holding the securities behind these mortgages? This option sounds great when you picture such investors as Wall Street fat cats but less attractive when you consider the reality that these investors are retirement and pension funds (or, again, taxpayers). Through securitization, these investors provided money to borrowers to buy homes and now homeowners are telling investors that their willingness to pay them back was contingent on home prices never falling?
Third, there’s the issue of picking asset classes to favor. According to Zillow, home values are down roughly 23% from their peak in 2007 (excluding foreclosure sales). But the stocks that make up the S&P 500 are still down 21% from their peak in 2007. Both the fall in home values and stock or retirement portfolios have wealth effects, meaning that the diminished value of a household’s cumulative wealth makes them feel poorer and, as a consequence, save more of their income in order to compensate. If we’re going to compensate for home value declines, should we also compensate households for their losses in the stock market? And keep in mind also that housing already receives substantial government support in the form of the mortgage interest deduction, the subsidization of long-term mortgages via Fannie and Freddie, and recent federal home buyer tax credits that totaled almost $30 billion, just to name a few of the policy supports for housing.
Fourth, there’s the issue of basic fairness among borrowers. Are we really prepared, as a nation, to write down the debt of somebody who paid 5% down and suffered a 15% decline in home value versus somebody who put down 20% and suffered the same loss in home value?
Don’t get me wrong. There are plenty of things that we can be doing to help housing, some of which I outlined in an earlier piece. As much as I try though, I just can’t see how universal principal reduction is one of them.