In 1902, faced with an outbreak of smallpox, the City of Cambridge, Massachusetts, adopted a mandatory vaccination law. Challenged by a Mr. Henning Jacobson as an unconstitutional infringement upon his liberties, this intrusion on individual rights was nonetheless upheld by the U.S. Supreme Court. Even more intrusive quarantines have been found lawful as a means to stop the spread of plague, influenza, and other cascading threats to the public health and well-being.
Today, our country faces a different kind of epidemic. With house prices having plunged again in November at possibly an all-time record rapid drop, roughly 12 million borrowers now owe more than their homes are worth—double the number from a year earlier and expected to rise to nearly 15 million this year—while another 8.1 million foreclosures are expected over the next four years. Over 1 in 10 Americans are in mortgage default. It is time to re-evaluate how we think of the situation.
By any reasonable measure, we confront a spreading foreclosure epidemic that is eating away at the core of the nation’s economic health. However well-intentioned, private and governmental efforts to date have not contained the damage. In the early stages of a public health crisis, voluntary treatment of the ill also fails to stop the spread of disease. What makes certain epidemics so devastating is that normal delivery systems for patient treatment are overwhelmed by the sheer number of cases all happening virtually at once.
Moreover, epidemics often infect health workers themselves, further weakening the normal recovery systems. And when rising illness rates and falling resources combine, the health care system is further left unable to help other ill patients, who themselves then get sicker than they might in normal times.
Looking at the current foreclosure crisis as an epidemic, the parallels emerge. At a normal rate of borrower defaults, the financial system can “clear,” in industry parlance, bad assets such as troubled home mortgages through workouts and occasional foreclosures. Today, however, it is abundantly clear that multiple foreclosures in many communities are infecting neighboring homes with rapid value dissipation. If left unchecked, this will lead to further community malaise due to lost tax revenues, increased crime and fire prevention, and a general draining of public resources.
Similarly, some players in the financial system who could have addressed scattered defaults themselves are “sickened” when foreclosures soar. Over 100 mortgage companies that originated many of the subprime mortgages are now out of business, and servicers who remain suffer capacity shortages to deal effectively with all the borrowers in need. Finally, homeowners with prime mortgages or good incomes who might have not gone into default in normal times now see themselves also “upside down,” owing more on their home than it is worth in the market, leading to home equity lines being called, or lacking home equity to deal with what would otherwise be normal borrowing for unexpected setbacks, college tuitions, and the like.
The upshot: Entire communities have become economic casualties of the main epidemic, and this plague continues spreading. Consequently, it is time we consider stronger measures—the economic equivalents of a quarantine. What can be done? Several extraordinary actions for extraordinary times need to be given greater urgency.
Over nine months ago, the Center for American Progress put forward a proposal by Michael Barr and James Feldman to modify the Real Estate Mortgage Investment Conduit, or REMIC rules to open a path for the servicers of loans to accelerate modifications and prevent unnecessary foreclosures. In 2009, we need to go a step further than simply implementing these needed changes.
REMIC status offers an enormous tax benefit to investors in the residential mortgage trusts that hold millions of mortgages. Many individual mortgages held in these pools are heading toward foreclosure. Recognizing that REMIC status is a special privilege, it is time to revoke REMIC status for any residential home mortgage loan-holding entity that forecloses on more than a certain percentage of all of its mortgages.
This step, alongside other REMIC and accounting changes outlined in the CAP proposal and elsewhere, would free up the ability of mortgage service companies that collect individual mortgage payments and distribute them to their investors to modify troubled home mortgage loans, or sell them off at a discount. The potential revocation of REMIC status would dramatically incentivize loan servicers to halt foreclosures and restructure loans to affordable levels, or sell them to those willing to do so Getting defaulted mortgages out of the hands of mortgage servicers so that systematic modifications based on sustainable principal and interest payments is perhaps the only broad-based approach likely to turn around the current price plunge. Congress already authorized the Treasury Department through its Troubled Assets Relief Program to buy up troubled mortgages, and previously funded the Federal Housing Administration as a source of refinancing. But to date, servicers have not been sellers. The economy cannot afford any longer to wait for them to decide to seek the economic equivalent of medical help. We need to put mortgages into temporary foreclosure quarantine.
National foreclosure moratorium
In the 1930s, state after state adopted moratoriums on foreclosures, dramatic action upheld by the U.S. Supreme Court. While hardly the best course of action in normal times, barring foreclosures to stem the downward spiral is a necessary part of a quarantine approach.
Even with the REMIC law changes, the sale of mortgages into the control of parties motivated to make lasting loan modifications will take some time under the best of circumstances. Congress could begin with a six-month moratorium, a reasonable time for transfers to occur and extendable if the situation has not improved. But given the national economic consequences of the current foreclosure wildfire, a federal moratorium approach is justified both to stop further price declines and to make more aggressive loan modifications a better alternative.
Even the bankruptcy playing field
As an adjunct to these other measures, granting borrowers in bankruptcy proceedings the same mortgage modification rights enjoyed by commercial real estate owners and even second-home owners is long overdue. Currently, judges have no authority to force a lender to restructure a homeowner’s mortgage on a primary residence to a level that reflects the current home value. This puts all the burden of the loss—which clearly under today’s circumstances is a loss in value beyond what either party could have anticipated—only on the consumer.
Giving homeowners the same bankruptcy options as enjoyed by Donald Trump is a fairer way to spread the burden of the current downturn and gives lenders a needed incentive to reach a more realistic modification to avoid the bankruptcy courts to begin with. Even those in the financial services sector that have long opposed such a move, among them Citigroup Inc., the National Association of Home Builders, and the American Bankers Association, recognize this course of action may now be needed. Indeed, serious studies have concluded that “mortgage markets are indifferent to bankruptcy modification risk.”
Stronger government interventions in the market such as these will inevitably raise objections. Some will argue that any change in the current status quo will amount to a “taking” of private property. The power to take such actions, however, was upheld in the Depression era, and in other cases of economic necessity in the past. Indeed, forcing the sale of mortgages outright by invoking eminent domain using existing statutory powers was recently advocated by Harvard Law School Professor Howell Jackson.
In the end, the takings issue boils down, in the situation of a frozen malfunctioning market, to whether the government is paying owners just compensation. The financial complexity and split ownership of mortgage-backed securities in which most mortgages are now bundled, combined with buyers sitting on the sidelines while prices plunge, makes it almost impossible for the marketplace to function properly. Market dysfunction requires government action even though this may be contentious, and our legal system has well-established mechanisms for looking back and valuing property after it is taken.
Others will assert that some of the proposed actions will distort the market, but that talismanic argument is belied by recent financial history. If swifter action by regulatory authorities had been taken initially to prevent the widespread selling of poor mortgage products, and then to recognize the full scope of the home mortgage crisis and prevent foreclosures, then our government would not have had to intervene in the economy in a manner so forceful that it could hardly have been imagined just 12 months ago. Given widespread current market failure, bolder actions are necessary in the short term precisely because we need the government to help restart a normally functioning market balance between sellers and buyers of homes along with a stable home mortgage finance system.
Finally, a common argument against intervention is the refrain that since 90 percent of borrowers are still paying their mortgages, any action to help defaulted borrowers avoid foreclosures will somehow induce more borrowers to go into default. Yet the vast majority of the 90 percent who have not yet defaulted will not be eligible for any modification as they still have reasonable equity cushions above their mortgage balance, and/or their loan payments relative to income are below the modification guidelines.
It is possible that at the margin, some borrowers looking ahead to a time when they expect to hit trouble may default sooner. But defaulting still comes at a great cost to the homeowner—a bad credit rating, very time-consuming workout process, and heavy financial scrutiny. And of course it is not as if we don’t do these interventions, then no more borrowers will go into default. The cost of staying on the current course is almost certainly millions more foreclosures, and a dramatic further drop in values for the rest of us.
As with a health epidemic, there is no way to perfectly match those who need treatment with the remedies necessary under extreme circumstances. Some who may get pulled into the quarantine who would have recovered without it. But if conventional remedies were working, then things would not have reached today’s epidemic proportions.