Bailing Out the Homeowner under water

Representative Barney Frank proposed a plan to the lenders to recover most of their mortgages and to help homeowners avoid foreclosures:

  1. Agree to cut the mortgage to 90% of present value of the house
  2. Pay additional 5% to FHA, for a total loss of 15%
  3. FHA will take over the mortgage from the lender
  4. If the homeowner sells the house at a later time for a higher price, they agree to pay “some profits”.

This plan is not good in two ways. First, while Barney Frank says this helps the lender recover most of the mortgage that is under water, he is looking at this one mortgage at a time and not as the aggregate. The expected value of Mr. Frank’s plan is lower than that of foreclosure. Say the median value of house is $250,000, and let us assume the mortgage is of the same size. If one such house goes under foreclosure, the lender would lose $250,000 (assume they lose substantial value in selling the foreclosed house) but if they accept Mr. Frank’s plan, they would only lose 15% of 250,000, that is $37,500.

But according to the statistics quoted by Hank Paulson, the treasury secretary, only 2% of the homes go under foreclosure. That is, a lender will see this as 2% chance that a mortgage has to be written off. The expected loss is $5000, way below $37,500. Only at 15% foreclosure rate, will the two plans look identical and the lender will be indifferent to these options. There is a possibility that lenders may also try to sell selectively the high risk mortgages.

Second, it does not explain the implementation of profit recovery from the homeowner. Even if this is spelled out, due to political reasons this would never get implemented, there will be huge outcries about the FHA taking over people’s wealth. If the homeowners think this is enforceable they will have no incentive to keep the house up to sell it at a price higher than their mortgage. This also incents people buying houses to take on larger mortgages, the very behavior that led us to the housing crisis.

So the bailout plan will result in spending tax payer dollars without adding value.

There is a risk that lenders may accept this. Some predictions by say that the percentage of mortgages under water could reach 25% by early 2009. This may cause the lenders to reevaluate their risk models and selectively sell just the high risk ones to FHA, which will end up with a portfolio of all bad mortgages that have to be written off at the expense of taxpayers.