Partial Mortgage Jubilee Plan from US Fed

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Eco­nom­ic Reform Aus­tralia has just alert­ed me to a pro­pos­al for a par­tial mort­gage debt for­give­ness pro­pos­al put for­ward by econ­o­mists from the US Fed­er­al Reserve in Jan­u­ary 2009. ERA repro­duced this post from WhoWhat­Why, which in turn referred to a Boston Fed pub­li­ca­tion Com­mu­ni­ties & Bank­ing and the paper “A pro­pos­al to Help Dis­tressed Home­own­ers”.

The pro­pos­al includes the sug­ges­tion of a grant to home­own­ers who are both in neg­a­tive equi­ty and unem­ployed, where the grant would pay up to 25% of the repay­ment costs over a 2 year peri­od.

I’m not­ing it here both for its own mer­it, and because it shows that a direct grant to debtors is fea­si­ble with­in the Fed­er­al Reserve system–something that I have seen dis­put­ed else­where. So a full debt-Jubilee, which I dis­cussed in my BBC HARDtalk inter­view, is also fea­si­ble. Since the Jubilee issue is like­ly to rise in promi­nence in com­ing years, it’s worth record­ing this very ear­ly pro­pos­al that emanat­ed from with­in the US Fed.

Below is the text of the paper.

A Proposal to Help Distressed Homeowners

by Chris Foote, Jeff Fuhrer, Eileen Mauskopf, and Paul Willen

With job loss­es gen­er­at­ing more mort­gage delin­quen­cies, pol­i­cy­mak­ers might con­sid­er whether fore­clo­sure-pre­ven­tion efforts should help home­own­ers with pay­ments for a while. We pro­pose a gov­ern­ment pay­ment-shar­ing arrange­ment that would work with the homeowner’s exist­ing mort­gage and sig­nif­i­cant­ly reduce month­ly pay­ments while the home­own­er is unem­ployed.

We believe a pay­ment-shar­ing plan stands a bet­ter chance of pre­vent­ing fore­clo­sures than longer-term but less sig­nif­i­cant pay­ment reduc­tions achieved through loan mod­i­fi­ca­tion.  More broad­ly, pay­ment shar­ing could not only ben­e­fit par­tic­i­pat­ing home­own­ers, but also could pro­tect the hous­ing indus­try from esca­lat­ing fore­clo­sures and could sta­bi­lize finan­cial mar­kets and the econ­o­my.

In our view, pre­vi­ous plans based on long-term loan mod­i­fi­ca­tions, have been stymied because (a) con­trary to the com­mon wis­dom, lenders and mort­gage ser­vicers will not always find a mod­i­fi­ca­tion to be in their best inter­est, and (b) extant plans are gen­er­al­ly unable to offer mod­i­fi­ca­tions to those who become unem­ployed.

The pay­ment-shar­ing plan we pro­pose has nei­ther of those draw­backs. It could take the form of either a loan or a grant. In both ver­sions, the home­own­er would have to pro­vide proof of job loss—or oth­er sig­nif­i­cant income disruption—and proof of the home’s neg­a­tive equi­ty.

Plan Features

Neg­a­tive equi­ty does not by itself lead to default unless the amount is extreme­ly high. Own­ers with neg­a­tive equi­ty who have not suf­fered adverse life events (for exam­ple, job loss, divorce, or ill­ness) gen­er­al­ly stay cur­rent on their mort­gages. Neg­a­tive equi­ty is, how­ev­er, a nec­es­sary con­di­tion for default. Bor­row­ers who have pos­i­tive equi­ty usu­al­ly can sell or refi­nance. The rea­son that fore­clo­sures are ris­ing today is that falling hous­ing prices have increased the preva­lence of neg­a­tive equi­ty at the same time that unem­ploy­ment is rising—the so-called dou­ble-trig­ger effect.

The best way to pre­vent fore­clo­sures right now is by the gov­ern­ment offer­ing bor­row­ers who have expe­ri­enced income dis­rup­tion some tem­po­rary but sig­nif­i­cant assis­tance. The two ver­sions of our pro­pos­al have five fea­tures in com­mon. First, the gov­ern­ment pays a sig­nif­i­cant share of the household’s cur­rent mort­gage pay­ment (25 per­cent and up) direct­ly to the mort­gage ser­vicer. Sec­ond, the government’s share of the mort­gage pay­ment is equal to the per­cent­age decline in fam­i­ly earned income. Third, proof of a recent and sig­nif­i­cant income dis­rup­tion is required. Fourth, the assis­tance ends upon resump­tion of the borrower’s nor­mal income stream—or after two years. Fifth, the plan caps the max­i­mum gov­ern­ment pay­ment (say, at $1,500 month­ly).

Addressing Challenges

The most dif­fi­cult design chal­lenge is to avoid attract­ing home­own­ers who don’t need help and inad­ver­tent­ly let­ting them game the sys­tem (a phe­nom­e­non called moral haz­ard). Eli­gi­ble home­own­ers would have to prove that their equi­ty is either essen­tial­ly zero or neg­a­tive. In the loan ver­sion, pro­gram par­tic­i­pants would pay an inter­est rate reflect­ing the ele­vat­ed risk the gov­ern­ment is assum­ing. And the grant ver­sion would explic­it­ly exclude home­own­ers hav­ing enough income (or wealth) to con­tin­ue mak­ing mort­gage pay­ments despite neg­a­tive equi­ty.

The Loan Version

In the loan ver­sion, the government’s pay­ments  accrue to a loan bal­ance to be repaid with inter­est at a future date. Gov­ern­ment pay­ments end when the homeowner’s income stream has been restored, or after two years, whichev­er is soon­er. Because the household’s mort­gage pay­ments may rise (for exam­ple, with an adjustable-rate mort­gage), the government’s pay­ment is capped at a pre­de­ter­mined amount. When bor­row­ers stop receiv­ing gov­ern­ment pay­ments, they begin repay­ing them. They have five years to do so. If the home is sold for more than the val­ue of the mort­gage bal­ance, the gov­ern­ment has first claim on any remain­ing equi­ty, up to the val­ue of the loan bal­ance, includ­ing accrued inter­est.

If after the pay­ment-assis­tance peri­od, the home­own­er still can­not  afford the month­ly pay­ment on the orig­i­nal mort­gage, the fore­clo­sure process may begin. The gov­ern­ment might then seek loan repay­ment as it would for edu­ca­tion loans—for exam­ple, by plac­ing liens on future income.

The Grant Version

In the grant ver­sion, the gov­ern­ment would pro­vide at least 25 per­cent of the month­ly mort­gage pay­ment for up to two years with­out requir­ing repay­ment. Home­own­ers whose adjust­ed gross income (aver­age income in the two years pri­or to income dis­rup­tion) exceeds a to be spec­i­fied mul­ti­ple of medi­an fam­i­ly income in 2008 would not be eli­gi­ble, a use­ful if imper­fect means of exclud­ing very high-income home­own­ers who like­ly have accu­mu­lat­ed sig­nif­i­cant wealth to self-insure against tem­po­rary income loss.

Advantages and Disadvantages

The plan pro­vides a sig­nif­i­cant but tem­po­rary  reduc­tion in the homeowner’s pay­ment dur­ing the peri­od of income loss—an advan­tage over loan-mod­i­fi­ca­tion pro­grams, which do not always low­er pay­ments suf­fi­cient­ly and some­times even raise them—by adding missed pay­ments to the out­stand­ing loan bal­ance. For lenders, ser­vicers, and sec­ond-lien hold­ers, the plan con­tains a more real­is­tic recog­ni­tion of their incen­tives and no pres­sure to do mort­gage mod­i­fi­ca­tions. Even if fore­clo­sure can­not be avoid­ed when the gov­ern­ment aid ter­mi­nates, the hous­ing mar­ket is like­ly to have recov­ered enough that dis­pos­al of the prop­er­ty will gar­ner a high­er price.

On the down­side, the plan prob­a­bly can­not stop home­own­ers who have extreme neg­a­tive equity—say, 40 per­cent or greater—from default­ing when gov­ern­ment aid ends. Indeed, the plan may mere­ly delay fore­clo­sure with­out any guar­an­tee of eco­nom­ic or social ben­e­fit. Anoth­er con­cern is that the bor­row­ers who should get help may choose to default rather than pur­sue a gov­ern­ment loan. Mean­while, the grant ver­sion rais­es the poten­tial for moral haz­ard.

Final­ly, admin­is­ter­ing the pro­gram does require some coop­er­a­tion from mort­gage servicers—for exam­ple, giv­ing appli­cants their out­stand­ing loan bal­ances and some home-price infor­ma­tion. If the gov­ern­ment chose to offer pay­ment for such assis­tance, that would add cost.

Estimating Costs

The cost of the grant ver­sion is eas­i­er to esti­mate than the cost of the loan ver­sion. The civil­ian labor force is about 155 mil­lion per­sons. With the unem­ploy­ment rate at 9.4 per­cent in July 2009 and con­tin­u­ing high, more than 14 mil­lion work­ers will be unem­ployed. An upper bound on the share of unem­ployed per­sons who are like­ly to be home­own­ers is the nation­al home­own­er­ship rate of about 68 per­cent. That sug­gests 9.5 mil­lion unem­ployed home­own­ers. A very high upper bound on the share of unem­ployed home­own­ers like­ly to have neg­a­tive  equi­ty is 35 per­cent, which implies that about 3 mil­lion per­sons would be eli­gi­ble for the pro­gram. Accord­ing to nation­wide data on indi­vid­ual mort­gages, the aver­age  mort­gage bal­ance of those who are 60-plus days delin­quent is approx­i­mate­ly $200,000, with an aver­age inter­est rate of 7.7 per­cent.

Assum­ing a 30-year amor­ti­za­tion sched­ule, the aver­age year­ly pay­ment is $17,111. If the gov­ern­ment pays 50 per­cent of the year­ly cost on aver­age, then the cost of pro­vid­ing help to 3 mil­lion home­own­ers is about $25 bil­lion annu­al­ly, per­haps $50 bil­lion over­all. That amount is low­er than the costs of oth­er fore­clo­sure pre­ven­tion plans.

The loan version’s cost would be small­er. Indeed, if all par­tic­i­pants paid back their gov­ern­ment loans, the pro­gram would cost vir­tu­al­ly noth­ing in present val­ue. Some bor­row­ers, how­ev­er, will default, and the gov­ern­ment may there­fore incur unre­cov­ered costs. It is hard to esti­mate  the degree of default, but the num­ber is like­ly low­er than in exist­ing pro­grams. Although no pro­gram for pre­vent­ing fore­clo­sures is per­fect, we believe that ours has the best chance of suc­cess because it address­es two of the lead­ing caus­es of cur­rent fore­clo­sures in a way that oth­er plans can­not. Pol­i­cy­mak­ers may decide the plan needs tweak­ing, but the spillover effects of esca­lat­ing fore­clo­sures call for urgency.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.