Negative Equity Mortgages:

At the end of 2009, 11.3 million residences were worth less their mortgage balances. In 5 million of these, the value of the property was less than 75% of the mortgage balance.

If a home is worth substantially less than its mortgage, public policy should be aimed at reducing the mortgage balance so that something like the original loan to value ratio is restored. I explain below why this is sensible.

If it is impossible to reduce the mortgage value, many of these deep under water households will opt for a strategic default. In a strategic default, property owners who can afford to continue their mortgage payments stop making payments because it is contrary to their economic interest. Many families avoid choosing the strategic default option because of the mistaken belief that it is immoral. Strategic default is the right thing to do for families who do not have strong non-economic reasons for staying in their under-water home.

Mortgage modifications are not going to happen on any large scale unless there is massive political pressure. Even if mortgage holders were willing to modify mortgages, handling each one on an individual basis is administratively impossible. I will discuss how to automate mortgage modifications in a future blog.

The underwater home problem gets much less attention than it deserves because the households affected are not organized. Strategic defaults that take place one at a time get very little attention.

Suppose the affected homeowners were organized. Then, instead of individual households quietly defaulting with no publicity, batches of thousands might announce that they planned to opt for a strategic default on a given future date if a sensible loan modification program was not available by that date. Each such announcement would constitute front page news and would command considerable attention. There is a terrific opportunity for some grass roots organization here. Move-on.org seems to be asleep at the switch. The mortgage situation is not even among its top ten priorities. Move-on.org, we need you!

If there is no practical program available to eliminate negative equity by reducing the loan balance, then strategic default may be preferable to continuing to pay on an underwater mortgage. There are five main reasons.

· It is the right thing to do.

· It will reduce the moral hazard that now encourages banks to make bad mortgages.

· It will give the Obama administration a second chance to heal the banking system by eliminating some large zombie banks and resurrecting them as real banks.

· It will reduce the dead weight losses associated with foreclosure.

· It will reduce the property deterioration that is likely to occur over time when the homeowner has no equity in his home.

It is the right thing to do.

Millions of homeowners made bad decisions by paying too much for residential property during the housing boom. They are paying dearly for their mistakes, and nothing I am proposing amounts to a bailout for them. But the banks and other financial institutions that originated these mortgages or that purchased the securities based on them also made the same mistake. Real estate finance professionals should have been in a better position than Joe Homeowner to recognize that a housing bubble was inflating.

It will reduce moral hazard.

The banks claim reducing mortgage balances will provides a reward for homeowners who purchased more house than they could afford. Therefore principal reductions create moral hazard and are bad. That argument is a two-edged sword. If banks accepted a home as collateral for too large a mortgage, then forcing homeowners to repay the entire mortgage encourages banks to make lend more than is prudent.

It will turn zombie banks into real banks.

In the first half of 2009 the Obama administration faced the problem of what to do with banks that were effectively insolvent because they had too large a proportion of toxic assets on the balance sheets. A number of prominent economists, including Paul Krugman, Joseph Stiglitz, Simon Johnson, Nouriel Roubini and others, suggested nationalizing the weak banks, stripping out their toxic assets in a government owned bad bank and then selling a cleaned up bank back to the market. Geithner, Summers, et al opted to continue the Bush-Paulsen policy of bailing out the weak banks with taxpayer money. These banks have pretty fallen into the Zombie bank role as was predicted. So with the economy awash with liquidity and banks able to borrow at near zero interest rates, ordinary business still find that credit is extremely tight. If there was a massive reduction of the principal balances of mortgages to reduce the underwater home problem, then some of these banks would found to be insolvent again. And the government would have a second chance to reorganize them the right way and create real bank out of zombie banks.

It will eliminate the dead weight losses due to foreclosure.

Foreclosing on a residential property has been estimated to cost the foreclosing bank $75 to $100 thousand. These costs include such things as legal, appraisal, and brokerage fees, maintenance and repairs on the foreclosed property, security expenses, insurance etc. It does not include the decline in the value of neighborhood property that occurs when a house is foreclosed. Foreclosures rarely occur on homes that have reasonable amounts of positive equity. In that case, homeowners who can’t afford to keep up with the mortgage payments are likely to sell rather than default. For every million foreclosure avoided, society saves $75 to $100 billion.

It will reduce the property deterioration.

The occupant of a home under water is more like a tenant with a bad landlord, than like a homeowner. He will make only those improvements that can be justified by the services they provide him during the time he expects to remain.