Nearly half a decade into what is arguably the worst foreclosure crisis in U.S. history, our central bank last week chimed in on how the Obama administration, Congress, and federal regulators can help revive the leaden housing market. In an unusual move, Federal Reserve Chairman Ben Bernanke Wednesday sent a white paper outlining the problems facing the U.S. housing market to the congressional committees in charge of banking and financial services.
It’s especially rare for the Fed’s Board of Governors to release such a policy paper without a formal request, which signals the severity of the situation before policymakers in the coming months. “Restoring the health of the housing market is a necessary part of a broader strategy for economic recovery” Bernanke wrote in a letter accompanying the white paper. The Fed’s intention was to lay out a “framework for thinking about certain issues and tradeoffs that policymakers might consider,” Bernanke wrote.
As the paper explains, the housing sector remains one of the biggest drags on our economy, impeding efforts to grow and create jobs. Home prices have declined 30 percent from their peak—representing about $7 trillion in lost household debt—leaving about one in four homeowners “underwater,” owing more on their homes than the properties are worth. Families digging their way out of mortgage debt are not spending as much on clothes, food, and other consumer goods, making businesses leery of investment. Homeowners uncertain of the value of their property are reluctant to invest in renovations and upgrades. And a glut of foreclosed properties on the market is depressing home prices and keeping new housing starts low, dragging down demand for building materials, appliances, and other homeowner purchases.
To make matters worse, the foreclosure crisis is far from over. Banks and Wall Street firms have foreclosed on millions of homes since the crisis began—nearly three million in 2010 alone—and an estimated 7 million more are still at serious risk, according to analysis from Morgan Stanley.
The message is clear: Unless we find better solutions soon, the housing market will likely stifle our already-fledgling economic recovery. And as the Fed’s white paper points out, many of the actions taken by lenders, servicers, and the mortgage giants Fannie Mae and Freddie Mac to minimize short-term losses are actually harming the broader housing market recovery.
To be sure, Congress and the Obama administration have already taken critical steps to help lessen the blow of the housing crisis since it began in 2007. The administration took another meaningful stride last month by appointing housing expert Michael Stegman as a counselor to Treasury Secretary Timothy Geithner. Stegman has decades of experience in housing policy, including as an assistant secretary for policy research at the Department of Housing and Urban Development during the Clinton administration, the founder of the University of North Carolina Center for Community Capital, and most recently the domestic policy director at the John D. and Catherine T. MacArthur Foundation.
But more must be done. The Fed’s white paper lays out several of the policy options before policymakers today, many of which the Center for American Progress has long supported. In anticipation of the State of the Union address later this month, we urge President Obama, Congress, and federal housing regulators to heed the Fed’s warning and make housing a centerpiece of the economic agenda for 2012, starting with the following initiatives.
Establish a large-scale principal reduction initiative
Large-scale mortgage principal reduction—lowering the amount of money underwater borrowers actually owe on their mortgage—is perhaps the most powerful tool to deleverage household debt and lower monthly housing costs. As the Fed’s paper points out, 12 million mortgages are underwater today, adding to about $700 billion in negative home equity. A carefully-designed principal reduction initiative “has the potential to decrease the possibility of default … improve migration between labor markets … improve a household’s financial condition … and reduce the incentive to engage in ‘strategic’ default,” according to the white paper.
Consumer and investor advocates alike have advocated for principal reduction as a way to stem further foreclosures simply by recognizing losses that have already been sustained. Instead of removing the families and then holding and maintaining foreclosed properties only to sell them at significant losses, thereby further reducing values of neighboring properties, lenders would recognize lost value and structure a better deal with the existing owner.
It sounds simple, but any write-down initiative must be carefully crafted to limit losses to lenders, investors, and taxpayers. One opportunity (and one that would not require congressional action) is the ongoing settlement negotiations between state attorneys general and mortgage servicers accused of faulty foreclosure practices. The AGs should set aside most—if not all—settlement dollars to principal reduction and restitution.
A more ambitious and likely more potent initiative would dedicate public dollars to write-downs for targeted borrowers that are likely to default without a principal reduction, likely through Home Affordable Modification Program’s Principal Reduction Alternative. While it is admittedly difficult to target the most at-risk borrowers, several industry experts have recently supported large-scale principal reduction initiatives, including Laurie Goodman of Amherst Securities, former Vice Chairman at the Federal Reserve Alan Blinder, and President Reagan’s former Chairman of the Council of Economic Advisers, Martin S. Feldstein.
William C. Dudley of the New York Fed recently expressed support for one particularly promising approach, so-called “earned principal reduction.” It works like this: As a reward for staying current on payments, an underwater borrower is offered a lower principal, say, from 125 percent of the value of the property to 95 percent after three years of timely payments. This is one of a number of approaches that can protect homeowners from further declines in home prices, give lenders a share of any upside from future price appreciation, and reduce the moral hazard of “strategic” default.
Help more underwater homeowners refinance at lower interest rates
Today roughly 8 million mortgage loans owned by the nation’s two leading mortgage finance companies, Fannie Mae and Freddie Mac—both currently in government conservatorship—carry an interest rate of more than 6 percent. As the Fed white paper points out, many of these homeowners have been unable to take advantage of today’s historically low interest rates—currently around 4 percent—because of “low or negative equity slightly blemished credit, or tighter credit standards.”
The Home Affordable Refinance Program, or HARP, was established in 2009 to allow current but underwater homeowners to refinance at the hope of lowering monthly housing payments to avoid foreclosure. After relatively slow uptake in the program’s inaugural years, Fannie Mae and Freddie Mac recently announced major changes to the HARP program to attract more participants.
Fannie and Freddie need the support of their regulator and government conservator, the Federal Housing Finance Agency, to vigorously implement these new rules to help as many as 2.9 million homeowners lower their monthly house payments, but action shouldn’t stop there. More can be done to ensure greater participation of mortgage servicers, including relief on so-called “representations and warranties,” or contractual obligations based on previous claims of borrower income and other underwriting factors, to servicers that refinance loans they did not originate. FHFA could also require servicers to publicly report the number of HARP loans they have provided, creating public pressure for taking up the program.
Convert vacant government-owned foreclosed homes into affordable rental housing
The Federal Housing Administration, Fannie Mae, and Freddie Mac own about 230,000 foreclosed homes, mostly from mortgages insured or securitized before the housing bubble burst. As the Fed paper points out, this “swollen inventory” of so-called real estate owned, or REO, properties has met weak demand for single-family homes in recent years, putting substantial downward pressure on home prices. Meanwhile, rents have gone up in the past year, while vacancy rates for rental properties have “dropped noticeably from their peak in late 2009,” according to the Fed paper.
A minority of foreclosed properties are in good enough shape and in strong enough markets to be sold directly to families looking for a place to call home. For the rest, low home prices and weak demand for owner-occupied homes mean that selling hundreds of thousands of them into that market will depress prices for a long time to come. CAP recently laid out a set of priorities for removing a portion of these properties from the glutted for-sale market by converting them to affordable rental units, a process we call “Rehab-to-Rent.” In forthcoming analysis, the housing team at CAP will lay out in more detail how this process could help deal with the continuous flow of REO properties in the future.
Though promising, this initiative will not be easy. As the Fed paper mentions, the most important thing is to target the communities, buyers, and property managers that have the best chance of implementing the model successfully. Only then can Rehab-to-Rent help improve local housing markets, promote neighborhood stability, and expand the availability of affordable rental housing.
Establish fair consumer protections for mortgage servicing
The Fed white paper states that the mortgage-servicing industry was “not prepared for large numbers of delinquent loans” during the foreclosure crisis and “lacked the systems needed to modify loans, engaged in unsound practices, and significantly failed to comply with regulations.” At the same time, the current system of laws and regulations protect the interests of investors and mortgage servicers before the rights of consumers are ever considered, according to CAP Senior Fellow Peter Swire. Servicers currently have no fiduciary responsibility to protect consumers from improper acts and omissions by mortgage servicers.
CAP’s housing team recently called on FHFA to carefully consider consumers as it drafts new standards for the mortgage-servicing industry. At the very least, FHFA should include explicit consumer protections as part of any compensation standards and other rules affecting mortgage servicers. A more rigorous change to the compensation model—and one that’s mentioned in the white paper—would be to tie servicing fees to actual expenses incurred, or other changes to protect consumers from excessive costs.
It’s rare for the Federal Reserve Board to reach out for help from Washington, especially in such a public way. Clearly the Fed believes the housing market is critical to future economic growth, but they do not control the key policy levers. Policymakers should respond by using all the sensible tools at their disposal to help resuscitate the housing market and lay the foundation for a broader economic recovery.
John Griffith is a Research Associate with the housing team at American Progress.