As the U.S. credit markets continue to struggle and the economy further erodes, one of the most intriguing questions to ask is why is it costing trillions of dollars to address a problem that can be measured in the billions? The answer is that the foreclosure crisis, which is at the core of the nation’s credit market and economic problems, continues largely to be ignored. And, the resulting collateral damage it is triggering is growing with increasing ferocity.
According to Bloomberg News, to date, the federal government has provided $7.7 trillion of direct funding and credit to financial institutions to address the current credit market crisis. The overwhelming majority of that sum is paying to address the collateral damage stemming from foreclosures that are undermining home prices and, in turn, further eroding the asset base of financial institutions, undermining consumer access to home equity, dampening consumer confidence, triggering job losses, and weakening the economy.
Where this crisis will end, when, and how much damage it will cause no one knows. But the longer policymakers take to address its root cause, the more will be the continuing and growing damage to our financial system, economy, and way of life.
A Closer Look at the Problem
According to Moodys.com, an additional 5.2 million families may lose their homes to foreclosure through 2010. Massive numbers of foreclosures have driven home prices down 20 percent from their 2006 highs, with a further decline of at least 10 percent likely. Falling home prices are having multiple negative impacts on the economy and are the major reason why the bailout of the financial system now measures in the trillions of dollars, although addressing meaningfully the foreclosure crisis continues to measure only in the billions.
Falling home prices are turning mortgages upside down and predisposing an increasing number of homeowners to foreclosure. Currently, nearly 20 percent of mortgages exceed the value of the underlying properties they secure. That figure could reach 40 percent by 2010, according to New York University professor Nouriel Roubini. Falling prices also undermine the value of mortgage-backed securities and trigger losses on undercapitalized bond insurance contracts, in the form of credit default swaps, most visibly seen in the AIG fiasco.
Home price declines are taking equity away from consumers who have leveraged it heavily in recent years to compensate for stagnant or falling wages. And dropping home values are also undermining consumer confidence. These impacts combine to produce widespread job losses that, in turn, translate into more foreclosures. In October, the country lost 240,000 jobs and the unemployment rate reached 6.5 percent, the worst rate in 14 years. All signs are that we are facing a rate of at least 8 percent next year. The current crisis cannot be solved by focusing solely on housing and credit markets, but now must include some broader form of economic recovery package.
The Obama administration has signaled its desire to fund long-neglected infrastructure investments. This would be an important contribution to rebuilding the economy while investing in communities. The billions of dollars likely to be appropriated for infrastructure should be linked to and coordinated with other efforts to rebuild communities that have been damaged by the foreclosure crisis.
Federal Response to Date
With the exception of the voluntary efforts of HOPE NOW, and limited assistance from expanded Federal Housing Authority (FHA) underwriting, the federal government has pursued a series of liquidity-only interventions, starting with the rescue of Bear Stearns and continuing through the receivership of Fannie Mae and Freddie Mac, the propping up of AIG, and the facilitated sale or extension of preferred lines of credit or equity to several other institutions. The goals and purpose of the much-discussed $700 billion financial system bailout package (also known as the Troubled Asset Relief Program or TARP) has changed practically every week since it was enacted in September. Initially intended to buy so-called “toxic” financial assets, it was later transformed into an effort to bolster the capital base of banks. Most recently, it is being used to promote lending for credit card, automobile, and student loans.
Unfortunately, none of those funds has yet been aimed at ending the foreclosure crisis. But that’s been a matter of political will and national priorities, not a measure of the insolvability of the crisis.
Outlined below are five priorities that if pursued immediately would go a long way to leading the country out of the current credit and housing-market decline, and placing the economy back on firm ground.
1. Contain the current foreclosure crisis and purge predatory lending
To date, there has been no legislative response to address the magnitude and depth of the current foreclosure crisis. The most promising legislation has been an expansion of the Federal Housing Administration through a new Hope for Homeownership program. That effort was designed to enable the refinancing of up to 400,000 additional loans that likely are heading to foreclosure between 2009 and 2011. But for a variety of administrative and program design reasons, it has not attracted much interest.
As of the end of October 2008, only 111 loans were in the FHA’s Hope for Homeowners pipeline.
And, according to the FY 2009 FHA Outlook, The Department of Housing and Urban Development estimates that less than 20,000 households will use the program next year.
Voluntary modifications are also insufficient. In a sample of 3.5 million loans, Valparaiso University law professor Alan White found more than half of modifications did not result in lower payments. Moreover, most loan repayment plans have been of a short-term duration — many as few as 3 to 6 months. With so many loans exceeding the value of the underlying properties, principal write-downs are critical. But they are rare, occurring in as little as 5 percent to 7 percent of modifications, according to White.
Meanwhile, losses on foreclosures are rising, now approaching 50 percent. Data from the State Foreclosure Prevention Working Group, a coalition of 37 state attorneys general and the Conference of State Banking Supervisors, released in September, show nearly 8 of 10 seriously delinquent homeowners are not on track for loss-mitigation outcome. The reasons for the relative paucity of loan modifications range from a concern by servicers of being sued by investors to the incentive structure related to the manner in which servicers are funded.
In November, Federal Deposit Insurance Corporation Chairman Sheila Bair proposed a plan to modify and guarantee 3 million loans. This was the first major proposal by a government official to address the core issue undermining the credit markets and economy. Unfortunately, the Treasury Department tabled her idea, instead announcing the new use of TARP to promote credit card, automobile, and student loan lending. Bair has since posted a new loan-modification program on the FDIC Web site that would address 1.5 million loans. But so far, it has gained no political traction among Washington policymakers or the Treasury Department.
Earlier this year, the National Community Reinvestment Coalition (NCRC) proposed the establishment of a national Homeownership Emergency Loan Program or HELP Now. (See “Help Now, Not Later,” by John Taylor, Shelterforce, Spring 2008.) It would authorize the Treasury Department to buy loans in bulk, in a reverse auction, and at steep discounts (equal roughly to their current write-downs by financial institutions) from securitized pools. This would result in a relatively low cost to the taxpayers. The purchase discounts would be applied to the modification of problem loans to create long-term borrower affordability.
The advantage of HELP Now is that loans could be modified, repackaged, and resold immediately. The $700 billion financial system bailout package allows this type of program. Loans for which the purchase discounts remain insufficient to make them affordable, based on standard industry underwriting criteria, would be refinanced with the use of government-provided soft second mortgages to be repaid by future home appreciation. Alternatively, those loans could be FHA insured. This approach would not be without cost, but the magnitude would be modest compared to the cost of failing to arrest the foreclosure crisis.
There are challenges with the HELP Now concept, related to legal restrictions on the sale of whole loans from securitized pools in contravention of pooling and servicing agreements (PSAs) between servicers and securities investors. But solutions have been offered by the Center for Responsible Lending (CRL) and the Center for American Progress. The TARP legislation could be amended to make changes to the tax laws that would compel modifications in the PSAs to remain eligible for favorable tax treatment.
In addition, CRL has recommended amendments to TARP that would complement the NCRC’s Help Now proposal, as well as improve and promote voluntary loan modifications. Those recommendations include: (1) Offer indemnification to servicers that responsibly modify or sell loans to the Treasury; (2) compensate servicers in the amount of $1,500 in order to offset the current fee structure under which servicers currently operate that benefits them to move loans to foreclosure rather than modify them; (3) guarantee modified loans (the idea behind the FDIC’s loan restructuring proposal); and (4) purchase second liens that complicate loan modifications and that currently are largely under water.
Finally, the much-debated bankruptcy reform should be adopted immediately. Affording bankruptcy protection to borrowers facing foreclosure could enable more than a half-million households to seek immediate help at no cost to the taxpayer. And the change would likely assist many more by giving servicers the assurance they need vis-a-vis their loan investors. Servicers would have the option of modifying loans or having bankruptcy judges do it for them. The likelihood is that many more modifications would occur voluntarily.
Bankruptcy reform legislation that has been introduced during the current crisis is intended to be temporary and would apply to loans already outstanding. In fact, loans modified by a bankruptcy hearing would serve the interests of both the borrower and financial institution, because the typical foreclosure would be more costly. Making the bankruptcy change temporary and restricted to already originated problematic loans would eliminate the potential for negative impacts to the housing finance market.
Beyond stemming foreclosures, at least two other issues directly related to the foreclosure crisis and resulting damage demand attention. First, nonprofits and local governments need enhanced initiatives to identify vacant and abandoned properties, allowing for early intervention and preventive efforts to limit vandalism and crime. Second, many communities, particularly those in which foreclosures are concentrated, need programs to facilitate the transfer of ownership of foreclosed properties into a housing trust or a similar vehicle for renovation and return to affordable-housing use. Increasing demand for affordable rental housing on the part of homeowners losing their properties will also be a challenge. And because much of the housing stock being foreclosed upon is rental property, those families also are driving up the demand for additional rental accommodations.
A related issue is housing resale. Innovative products and approaches to homeownership could help, particularly, minority families and communities regain the losses they are disproportionately experiencing as a result of the foreclosure epidemic. Shared-equity mortgages, for example, hold great promise for bringing consumers who are unable to make large down payments but are otherwise ready for homeownership into the housing market. Under a shared-equity arrangement, an investor contributes some or all of the down payment for a home purchase in return for a fixed share of the future home price appreciation. (See Shared-Equity Mortgages, Housing Affordability, and Homeownership, by Andrew Caplin, James H. Carr, et. al., and “Homes that Last,” by John Emmeus Davis, page 18.)
Shared-equity mortgages would also be an important antidote to the market’s recent abuse of financially vulnerable borrowers. Shared-equity mortgages ensure that an investor’s equity is on the line and therefore the borrower’s and investor’s interests are aligned. And shared-equity mortgages can enhance affordability by reducing the debt obligation for homebuyers by as much as 20 to 30 percent relative to a no- or very low-down-payment product.
Lease purchase products are also promising, particularly in the current environment where the credit scores of potentially millions of consumers have been damaged. Despite their blemished credit histories, millions of household may, nevertheless, be fully prepared to own under reasonable financial circumstances. And lease purchase products might be the way to bring those consumers back into the homeownership market.
2. Purge predatory lending from the housing markets
The enormity of the current credit-market and economic crisis has led to a heated debate about the root cause of the subprime market meltdown. Two arguments dominated in mainstream media. The first was that the Community Reinvestment Act (CRA), a law that requires banks to meet the legitimate credit needs of the communities they serve, forced lenders to make bad home loans to unqualified low-income consumers. The second argument is that lenders were pressured by policymakers to increase homeownership among minority households that could not afford to own. Neither argument holds water.
First, according to a 2008 study by the Federal Research Board, between 85 to 90 percent of problem subprime loans were not originated through CRA. Second, according to the Center for Responsible Lending, less than 10 percent of all subprime loans made between 1998 and 2006 were to first-time homebuyers. During that period, the majority of loans in the subprime market were for refinancing. As a result, improving homeownership was not the principal aim of subprime lending.
Unfair, deceptive, and otherwise predatory lending practices, combined with an investor appetite for high-risk loan products, was the central cause of the foreclosure crisis. And although well known and thoroughly written about for more than a decade, it was not until this summer that the Federal Reserve Board issued revised Home Owner Equity and Protection Act (HOEPA) regulations to address a broad range of abusive lending practices from underwriting and appraisal practices to product marketing and more.
These revisions take an important step in enhancing consumer protection in the high-cost mortgage market. But consumers remain vulnerable to abusive mortgage lending practices. The yield-spread premium, for example — a cash payment given by a lender to a broker for higher-rate loans — is one of the most-cited abuses in the subprime market, yet it continues unchecked. Such practices demand a strong national anti-predatory lending law that can complement the revised HOEPA regulations.
3. Reform regulation of the financial system
The current foreclosure crisis is a clarion call for financial system regulatory reform.
Financial institutions play a central role in the U.S. economy. The U.S. Department of the Treasury recently released a report that recognized the need to restructure the financial regulatory system. The report focuses heavily on advances in financial engineering and technological evolution, and the challenges presented by conflicts of interest, overlapping or confusing regulatory oversight or authority, and the growth of new international competitor financial systems. These are all important issues, but the current financial markets distress is rooted in more basic and fundamental issues, such as poorly regulated markets that allowed reckless lending behavior to permeate home mortgage lending.
The welfare of the financial institutions’ customers has not been the paramount focus of regulatory oversight. As Harvard University law professor Elizabeth Warren has artfully stated, consumers had better protection buying a toaster or microwave oven than they had when purchasing the family home. Rethinking the financial system should begin with the goal of enhancing the economic wellbeing of the American public. This means helping people, families, communities, and the nation to build wealth, enhance economic mobility, and ensure the nation’s economic competitiveness in an increasingly competitive global economy.
This goal should be self-evident, but it is not. We have millions of problem loans and hundreds of troubled financial institutions that demonstrate that it is possible for financial institutions to make extraordinary sums of money in the short-term while acting in a manner that is adverse to their customers’ — and ultimately their investors’ — financial needs. Going forward, financial system modernization cannot afford to ignore this lesson.
Understanding why millions of households are marginalized and what can be done to bring them into the financial mainstream of the 21st century should also be a priority of consumer-focused financial regulatory reform. Not everyone has the same potential to participate in the financial system. But with nearly 10 million unbanked households, more could be done to achieve a truly inclusive financial system. In fact, a recent report by the Center for Financial Services Innovation estimates that there are 40 million under-banked households in the United States.
These consumers disproportionately resort to high-cost payday and title lenders, rent-to-own businesses, and bill-payment and check-cashing services that erode the value of their earnings. Bringing them into the financial mainstream would enable them to better leverage their resources and engage the housing markets in a more supported and financially sophisticated way.
Finally, regulation of the financial system should encourage product innovation, particularly in mortgage products, in a way that might expand stable homeownership.
Banks might also be given access to risk-sharing financial pools to promote financial service innovation. And they should be rewarded beyond CRA credit for bringing consumers into the system. Tax incentives are an important and underutilized tool to promote financial service innovation and inclusion. Financial education should also be a key component of comprehensive financial system modernization to better engage the American public.
4. Reform federal housing policy
It would be a stretch to say that America has a housing policy. While successive administrations have had the general goal of increasing homeownership, and some have occasionally expressed the desire to promote mixed-income or supportive-services housing, there are few, if any, meaningful national objectives against which federal housing programs might be measured.
Rather than a policy, we have a range of programs that date back to the Great Depression — many of which are in need of serious overhaul. The U.S. population has changed dramatically over the past half-century and continues to change rapidly. These issues present a host of challenges and opportunities for the nation’s housing infrastructure. Moreover, energy and other environmental concerns are now major factors in housing policy considerations — considerations that were all but completely ignored a half-century ago.
These complex interconnections raise broad questions such as: What is the role of housing policy in promoting vibrant communities and the economic interests and social wellbeing of the population? And, based on how we answer that question, what are the relationships between housing policy and energy, transportation, education, and other national programmatic priorities? Suffice it to say that having a focused discussion on the goals of housing policy would inform our discussion of ways in which the financial system can play the most robust role in its support.
Beyond these macro issues, housing policy should address the unique shelter challenges of each segment of the population. In a recent lecture at Harvard University, former HUD Secretary Henry Cisneros suggested that housing can be viewed as an ascending continuum. The lowest step is homelessness, moving next to supportive housing and ultimately to long-term homeownership. Viewing housing as a continuum encourages policymakers to think of households as moving up a chain of successes, rather than approaching housing in a static context. This housing staircase can also be used as a tool to examine federal subsidies at each level—to determine where the allocation of public resources might be more effectively and appropriately redirected to create upward mobility.
The cost of producing housing is also a critical issue to be addressed in the context of a new national housing policy. Prior to the foreclosure crisis, America was suffering from rapidly growing affordability problems that reached from coast to coast. When the current inventory of unsold homes is off the market, those problems will return.
Inefficient land-use patterns artificially drive up the costs of housing and create problems. The silver lining of the recent energy price shock was the wake-up call that our current land-use practices are counterproductive to the public interest.
Although energy prices recently have fallen dramatically as a result of fears of a global recession, they will return to unaffordable levels when global markets rebound. As a result, federal policies should tie HOME, Community Development Block Grants (CDBG), and other housing subsidies — along with highway, mass transit, and other infrastructure funds — to communities’ sustainable planning and construction practices. This would help reduce the need for public subsidies to buy down the rents on unnecessarily over-priced housing. Addressing fundamental weaknesses in land-use regulations with the goal of providing opportunities to produce more housing, encouraging greater reliance on new and innovative building technologies, determining the benefits and costs of alternative green technologies, updating building codes, and streamlining permitting-and-approval processes, are the keys to better leveraging market forces to meet the housing challenges of the future.
5. Enforce fair housing and fair lending laws
Many of today’s housing problems, particularly those related to minority communities, result from chronic patterns of discrimination. Discrimination undermines the economic and social wellbeing of communities and limits the nation from reaching its full potential as a fully inclusive and competitive society. Unfortunately, 40 years after the passage of the Fair Housing Act, the laws protecting the rights and interests of minority families in the housing market remain poorly enforced.
A lack of funding is a major contributor to poor oversight of fair-housing practices. But money is not the only cause. A lack of appropriate coordination among various agencies responsible for enforcing civil rights and equal opportunity, and insufficient political will at the federal administrative level, have combined to undermine progress on this essential national mandate.
The time is right for the establishment of a cabinet-level agency focused on civil-rights enforcement. It would be responsible for measuring, monitoring, and eliminating all forms of discrimination. It would not supplant, but rather coordinate the civil-rights responsibilities of other federal agencies. The new entity would, however, have the authority to enforce the law in instances where agencies with principal civil-rights enforcement responsibility fail to carry out their mandates. And given the importance of housing to ensuring opportunities for social and economic advancement, housing-related laws would be among the agency’s highest priorities.
Enforcing the law would immediately open the door for millions of households that are prepared to access improved housing opportunities and for whom their only impediment is discriminatory action. This agency would develop and support public-service campaigns promoting a more integrated and inclusive society to help educate the public on this important issue.
The current period of economic turmoil is also a time for deep reflection and course correction. The longer it takes to act on the foreclosure crisis, the greater will be the needed intervention. In fact, given the economy’s recent slide, the nation is now in need of a significant stimulus plan to promote employment. Investing in new jobs without addressing the foreclosure crisis, however, will likely produce disappointing outcomes, similar to those resulting from the massive bank bailouts.
This is the time to think and act in bold ways to tackle the housing challenges facing the nation. We should approach this crisis environment as the opportunity to make significant and meaningful changes that lead to greatly improved affordable housing options, enhanced sustainable homeownership choices, and more thoughtfully and comprehensively planned and delivered community investment initiatives.