The government tries a new tack in the fight against mortgage foreclosures

Mar 31st 2010 | NEW YORK | From The Economist print edition

WITH America braced for 4m or more foreclosures this year, the government is still searching for an effective way to stop the rot in housing. Under the Home Affordable Mortgage Programme (HAMP), a mere 170,000 borrowers have received permanent loan modifications, well below the target of 3m-4m. Will a revamped HAMP, unveiled on March 26th, mark a turning-point?

Until now the focus has been on lowering mortgage payments as a share of income, mainly through interest-rate reductions and term extensions. New rules put an emphasis on reducing principal (ie, loan balances). A crisis first sparked by subprime-mortgage defaults has since spread to better-heeled borrowers: one in four American households with mortgages owe more than their properties are worth. Forgiving some of this debt makes it less likely that they will throw away the keys.

The new plan aims to help in four main ways. It offers incentives for loan servicers (which collect payments for investors in mortgage-backed securities) to reduce principal for those owing more than 115% of the property’s current value; the write-down will be staged over three years if the borrower keeps up with lower payments. Second, struggling borrowers who have kept up their payments can switch into loans guaranteed by the Federal Housing Administration (FHA), a government agency, as long as their loan is reduced by 10% or more. Third, jobless borrowers will get up to six months of payment assistance while they look for work.

The final element is perhaps the most important. The government hopes to remove a blockage in the modification process with a bribe to holders of “second lien” mortgages, such as home-equity loans. CreditSights, a research firm, estimates that the four big banks hold $423 billion of home-equity loans (see chart), $151 billion of them to borrowers who are either underwater or close to it. These lenders have resisted modification of first mortgages, fearing knock-on write-downs of their second liens. The sweetener on offer is a payment of between ten and 21 cents on the dollar for balances they cut.

The new plan is widely seen as having more teeth than the first version of HAMP. But it still has its flaws. Participation by servicer banks is not assured. The motivation to avoid modifying second liens is likely to be stronger than a few thousand dollars in incentive payments for investors and servicers. Even so, the plan appears to treat second-lien holders better than investors in the main mortgage, because the former are not required to cut principal when first-lien balances drop. This “undermines the priority of claims in the capital structure” and supports the overvaluation of exposures on banks’ books, says Joshua Rosner of Graham Fisher, a consultancy.

The taxpayer will still be stuck holding the bill for the FHA. Already, the agency’s reserves have been heavily eroded by risky loans it took on in 2008-09 to shore up the housing market. Even homeowners may end up feeling dissatisfied. It is jobs that these households really desire, says Anthony Sanders, a property-finance professor at George Mason University, not to stay in a house that they cannot afford, especially when rental properties are so readily available.