By Morris A. Davis
Today, we’re fortunate to have Morris A. Davis, Assistant Professor of Real Estate and Urban Land Economics at University of Wisconsin School of Business, as a guest contributor.
Research by economists inside the Federal Reserve system have shown that two events typically lead homeowners to default on their mortgage (see here). First, the value of the house must be less than the value of the mortgage (“under water”). This is necessary but not sufficient (see here). Second, homeowners must experience a significant disruption and loss of income. The available data suggest there might be a big increase in foreclosures in the immediate future. Zillow estimates that 22 percent of the 50 million homeowners with mortgages are currently under water; unemployment rates are high and are expected to remain high for the next two years.
Why does unemployment lead to a foreclosure when a house is under water? Consider the case of Wisconsin. In Wisconsin, UI benefits are capped at $1,452 per month. According to the 2007 American Community Survey, the average mortgage payment including all mortgages and taxes in Wisconsin is approximately $1,200. If the unemployed make their mortgage payment, they have roughly $63 per week available for food, transportation, and other necessities. After spending down their assets, the unemployed have no choice but default. They cannot sell their house, because they would have to write the bank a check at closing. They cannot make their mortgage payment, because they would have no money left for food.
The Obama Administration’s “HAMP” proposal to reduce foreclosures calls for modifying mortgage payments. Mortgage modifications are designed to help borrowers refinance from a “bad” subprime mortgage to a more conventional mortgage. The reason that many legislators and journalists think mortgage modifications are the solution to the foreclosure problem is that the delinquency rate on subprime mortgages is much higher than the delinquency rate on prime mortgages, 12 percent compared to under 3 percent in 2009:Q2.
Although the HAMP plan will help some borrowers, it likely will not help avoid the majority of people facing foreclosure. There are two related reasons for this. First, shown in the table below, in 2009:Q2, 52% of seriously delinquent homeowners have prime mortgages — so a “bad” mortgage is not the underlying problem. Second, because of the way the HAMP rules are written, the unemployed are essentially ineligible to have their mortgage refinanced. And, the research is quite clear that unemployment is a trigger to foreclosure.
There are two proposals out there that will prevent foreclosures for unemployed homeowners. One plan is from a team of researchers at the Boston Fed (Chris Foote, Jeff Fuhrer, Paul Willen) and Federal Reserve Board (Eileen Mauskopf), the so-called “Boston Fed” plan. The second is from my colleagues Stephen Malpezzi, François Ortalo-Magné and I here at the Department of Real Estate at the Wisconsin School of Business. We call this the WI-FUR plan. Both plans address the foreclosure problem by providing the temporarily unemployed with temporary assistance. Both plans attempt to mitigate the “moral hazard” problem by specifying that the amount of temporary assistance is independent of the original mortgage amount.
For each unemployed person, the Boston Fed plan (here for details) computes the percentage disruption in income due to unemployment (i.e. the gap between the wage while last employed and the UI benefit), and then pays that percentage of the mortgage directly to the mortgage servicer. This payment could be either a loan or a grant. The loss in income must be demonstrable and significant, at least 25 percent.
The WI-FUR plan (here for details) specifies that all unemployed receiving UI benefits also receive a housing voucher that can be used to pay the mortgage. The housing voucher would be computed such that, on average in each state, homeowners pay 30% of their UI benefits on their mortgage — the voucher would cover the balance. In Wisconsin, for example, we advocate for an average voucher of about $764. This would make up for the shortfall in a $1,200 mortgage payment if households pay 30% of their UI benefit ($436 = 0.30 × $1,452) towards their mortgage.
You could ask: Why prevent foreclosures? We’ve known or suspected for some time that foreclosures are costly in terms of time and process (see here); that foreclosures may have “spillover” effects on values of neighboring property (see here); and that foreclosures may affect the well-being of children (see here). But why prevent them now?
People that know me know that I was completely opposed to foreclosure relief in 2007 and 2008. At that time, my view was that homeowners that were being foreclosed on put little down on their property, so they had option value from homeownership with no risk. Further, during the foreclosure process, they lived in the house for free — no mortgage payment and no taxes. The economic and political environment has changed quite a bit since 2008, and my opinion has changed. Now, I can give two reasons for why, in late 2009, we should implement either the Boston Fed or WI-FUR plan.
First, my opinion is that we experienced two very large (and likely connected) aggregate shocks. I mention this because I want to emphasize that it is possible the foreclosures we’re observing now are not necessarily the result of ex-ante bad or risky decisions by lenders or borrowers, but of decisions that look bad ex-post due to bad luck. The first shock is that house prices have fallen by 30 percent nationwide since the peak in mid-2006. I describe this as a shock because traders appeared to think a big decline in house prices was a possible but low probability event. For example, the “Meltdown” scenario in a Lehman Brothers outlook as of August 2005, assumed to occur with only a 5 percent probability, called for a cumulative decline in house prices of about 15 percent over 3 years: See here. The second shock was the massive recession we just experienced. I describe this as a shock because many economists had become convinced the volatility of major macro aggregates had been cut in half due to the “Great Moderation” — see here for a recent paper. In a world with a great moderation, the severe recession we just experienced is a very unlikely event. When put together, the large decline in house prices (shock 1) and large increase in unemployment (shock 2) have resulted in an unprecedented surge in foreclosures.
Second, as a society we’ve committed to spend money to reduce foreclosures. So let’s spend it effectively. The Obama Administration has been authorized to spend $75 billion dollars to try to prevent foreclosures. The Treasury now is spending the money by paying servicers to modify mortgages. This plan might help some people, but it will not address the majority of future foreclosures from unemployed people with prime-rate mortgages. If we want to prevent foreclosures of this group of people, either the Boston Fed plan or the WI-FUR plan will get the job done.
This post written by Morris Davis.
It is a good plan but it still uses taxpayers dollars to bail out people who, rightly or wrongly, made a bet and lost. Life is not fair. But I, like many, saw this bubble and sat it out thinking that eventually there would be a correction and that when things over-correct on the downside I’ll dive in. I’m still waiting. I, like many, am watching the Case-Shiller index, have a job, am saving, learning how to buy a reo/foreclosed house (and wish to do so before our currency collapses).
I am well aware of the pain to society that has been inflicted and will be inflicted in future. I do not conflate, “let it happen” with “cutting off my nose to spite my face.” I have been unemployed before and know peoples’ pain. I may be laid off in future so (against economist wishes?) I am saving like mad. But then again, I didn’t sign a mortgage before I knew I could really ride out a rough patch. You place your bets and spin the wheel. That a large number of people did so and lost is not an argument to bail them out. But in abstract, it’s still a novel plan–do it with private money.
So long as you don’t see a deficiency judgement after a foreclosure, then foreclosure is financially a great deal for a highly stressed family of individual. And in the case of a family or individual that has spent down their assets and is relying on unemployment insurance as their primary income, who is going to bother filing for a deficiency judgement, which isn’t even possible in many states? The biggest reason to provide public money to schemes like this is to benefit the lenders. With the FDIC in dire financial straits, this ins’t a trivial concern, but this seems a wildly inefficient way to go about it. Better to force some serious bondholder haircuts or debt to equity swaps first – plus showing management the door for the evident reckless behavior of the last 5 years or so.
I too sensed that the “Black Swan” of the end of the housing boom and the associated housing boom/MEW fueled economy could be coming. It was also a constant topic of discussion among the non-economist and non-investment banker cicles I happen to hang around in. So we must be a paranoid lot, but wonder of wonders, it played out as we feared.
As far as the WI-FUR or any other plan goes, I would be happier with it if it was a loan rather than a grant. Also, it should include a means test which insures that applicants did really spend down savings and any sort of liquid investments before becoming eligable. Also that they must tap their 401K first, penalty and tax free of course, before becoming eliglible for any taxpayer funded assistance program.
Maybe this is a small percentage of those faced with foreclosure, but it seems like a useful safe guard to prevent scaming the system.
I like the idea of using a lottery to shuffle people around.
Part of the problem is that when default risk went up, buying slowed and so values on homes went down. This means that for many people, if they sell they are still stuck with a sizeable debt and no asset to lose if they default on it. And banks end up with an oversupply of properties it can only sell at firesale prices, which push home prices down further.
Here’s a way to mitigate some of the problem.
Upon sale or foreclosure, the bank gives the seller foreclosed properties it has on its books for the value, or partial-value, of the remaining debt. Or instead, the bank gives the seller a ticket for a possible poperty from a tranche of properties of a certain value, type, and location. The tickets could be traded as well and the bank could sell tickets openly too.
Morris,
Your plan doesn’t seem to take into account whether the mortgage is underwater. If it is, say by 20%, wouldn’t it still make sense for this unemployed worker to walk-away from the mortgage and use your voucher to rent?
And what is the difference between this and just raising the unemployment payment by 50%? About 10 million are receiving benefits, your plan would cost $7B per month.
The best solution so far seems to be to force
Hi Bob in MA and others:
We have in mind that the unemployed must (each month while collecting UI) prove they have a mortgage. If the vouchers only go to unemployed with a mortgage, our estimate is that it costs $2.5 billion per month at Aug-2009 levels of unemployment. These estimates are detailed in a spreadsheet on the WI-FUR web page.
We advocate a voucher (rather than additional UI) so that the money must be “spent” on housing or mortgages.
Also, historically, (approximately) 90% of underwater households keep making their mortgage payments. That proportion seems to be roughly true in the current environment. 2.7 percent of mortgages are 90 days delinquent, and approximately 20% of all mortgage holders are under water.
One reason I am suggesting we help this cohort of seriously delinquent unemployed borrowers (as compared to 2007 and 2008 vintages) is that they were making their mortgage payments, despite being underwater. Given they have made their mortgage payments despite the declining value of their house makes me believe these folks would not have defaulted if they did not become unemployed.
One more thought: My understanding is that we have to act soon. I’ve heard the data suggest we have another surge of foreclosures coming in the next few months.
Best,
Morris Davis
Morris,
I’m a hard working American trying to raise a family in these unsteady times. I have not been late on my mortgage payments but I am making less now then last year and I am hurting like everyone else.
If WE approve a plan to give a handout to my neighbor and nothing to me, I’m going to be pissed. Find a way to ‘claw back’ the LOAN in some way (reduce future Social Security benefits) and I might be on board.
Toss around free money and you just might alienate the rest of us trying to save a few.
What Eric said.
Prof. Davis;
I understand your arguments for preventing foreclosures, particularly in the current environment. As an expert in real estate, however, I’m hoping you can help me better understand some of the conflicting numbers I’m seeing about underwater mortgages.
When I look at the results of the Mortgage Bankers Association Delinquency Survey (http://www.mortgagebankers.org/NewsandMedia/PressCenter/70050.htm), they report that in 2009Q2 4.3% of “one-to-four-unit residential” mortgages were in foreclosure and 9.24% were delinquent. They break down those delinquency rates as 6.41% for prime loans and 25.35% for sub-prime. Those rates are roughly double the rates that you quote.
Are the MBA survey rates considered reliable? Is there a more reliable source that I should be looking at?
Second, as a society we’ve committed to spend money to reduce foreclosures. So let’s spend it effectively.
Morris,
With this statement you have broken with all the money cranks in Washington and academia.
I have to say that you plan is much better than anything I have heard coming from the gods in our political class, but as others have stated it is just too bad that they have put into such a bad situation that we have to resort to the use of government to spread the pain.
Until we learn that government is about spreading the pain not allowing the blessings of freedom we will continue to feel their pain.
Just to be clear, the first Eric and the second are different commenters. While I conceptually like the idea of making any helping hand a loan out of future benefits like Social Security, I think it is exceptionally improbable that our representatives would take the heat today to pass such a program and I think it 100% likely that even if passed today it would be eroded before the actual reconciliation occures. I really believe that foreclosure is an emotionally weighted phrase which masks the reality that it is really the very best “modification” available to folks with serious financial problems.
Can we just provide a social safety net for everyone. Low enough to provide food and rent for a decent place to live as well as an internet connection. The same for everyone across the board so we can at least stop worrying about food and shelter. Clothes are easy and cheap enough at your local Goodwill or ebay. For the folks who don’t want to live at minimal levels then they can work their back end off to do better. For the folks who don’t want to live in a 500 sq foot room can educate themselves to do better. You don’t really need to pay for classes or books anymore it is all on wiki and the internet. Learn yourself. For the folks like me who overspent and was self-employed but now down to my last dollars and don’t qualify for unemployment or any insurance plans or housing plans etc will just have to change lifestyle and live in poverty like conditions. At least without the stress of shelter and food for our love ones we are responsible for (aging divorced mother or children – one in the same). If you did well in the past you will do well again in time. If you live off the government then you can continue to live off the government. If your company goes bankrupt so be it.. If Goldman Sachs goes bankrupt let it go. It is absolutely ridiculous trying to find government programs to qualify for. Unless you are well connected with the poverty group you can’t find the programs you or your children or aging parents should qualify for. Whats up with the housing subsidies like section 8 and stimulus money for the homeless.. Even if you qualify it seems only the people in the know like the ACORN folks only know how to get help. It is completely unfair across board. If you can’t afford your house then move in to a small house like I did. If you want to try and start a business like me then plan on living in poverty for awhile. I have done it for 2 years Why do we think we have to help people stay in homes to big for them? If we are going to do this then please buy me a house because I needed help a year ago. Lastly implementing programs after many people have already been devastated is so unfair and makes a person bitter. Can you imagine if we increase the housing credit to 15,000. Think of all the folks who just overpaid so they could hit the 8,000 deadline. With every new program implemented they are created a subset of a very mean and mad group of people who are left out. Between this and the mad mad wall street bonus debacle how can we expect to ever live morally fulfilling lives again. It will be survival of the fittest meaning who “games” the most. We will essentially be Russia with black markets and bribes.
We were in the first wave of unemployment. My wife lost her job of 9 years. The unemployment after taxes was less than 50% of her prior income. We burned through a ton of savings and stabilized after 10 months. We cut, cut and cut. We kept the thermostat set at 62 degrees. Now we are back to saving and paying off excess debt just like most people are doing right now. We have relearned what we knew when we first were married. A saver not a debtor be, that is how Americans stay free. No more bailouts and cut the government to the bone. Let the banks fall and stop playing with the common peoples money.
We will survive and it is time for the rest of those out there to “Man Up!” Admit you screwed up and don’t do the same thing again!
What about those that rent? Aren’t you increasing moral hazard by systematicaly favoring one asset class (real estate) over others during downturns? I currently rent but would certainly buy if I believed I would get a reduced mortgage payment, at no current cost to me, if I lost my job.
And Cedric, why should 401k’s be allowed to be tapped tax free? I see no efficiency argument in favoring pre-tax savings over post-tax savings (Roth IRAs/401ks).
My proposal is not that we reduce the number of foreclosures but increase the speed at which they are completed. The market is seeking a clearing price (even for vacant FL towers) but is hampered by the many months it takes to complete a transaction. Imagine if it took six months to trade a stock; I doubt we’d rave about the efficiency of the market then!
I’m just about through with this country.
I’ve waited for a real correction in the housing market so I could pick up my house for the proper market-fundamentals price given stagnant family incomes and poor future prospects for the economy as a whole. I’ve lost too much to rent and devalued dollar savings.
This damn country wants to punish people like me and I’ve had enough. Our oligarchs want lots of taxes from our earnings to pay for wars we don’t need and yet deny us anything much back in return (like medical care), they want to devalue the buying power of our savings; they give tax breaks to speculators, bonuses to incompetents and frauds; they permit the filling of the airwaves with voodoo econo-sophistry and political science fiction that simply confuses people without enough education or time to spare, who would otherwise like to get useful and reliable information in order to make reasonable decisions as workers, investors, consumers, parents and voters.
The least they could do for people like me is allow me to grab a house in a great neighborhood a price that makes sense, considering the lousy standard of living I’m about to “enjoy” for the next several decades – attempting to save what little I can and pay for only the basics – as the US completes its downward trajectory into the basement of de-industrialization thanks to terrible decisions made during the last few decades on the part of foolish voters, even more idiotic home buyers, not to mention greedy and lazy leaders in business and government.
Do the prudent and thrifty ever get anything out of this – other than screwed by the rest of you aholes?
What kind of people is this country trying to encourage its citizens to be? Certainly not hard working, saving, prudent, ethical or FREE!
I’d like the WI-FUR plan better if the government got something for its money.
How about a piece of equity? If Joe Unemployed uses twelve $1,000 vouchers in order to remain in the house he purchased for $400,000, then the government owns $12,000 / $400,000 = 3% of the house value, to be recovered when the house is next sold (at arm’s length!), if not sooner.
I am the prudent and thrifty…I purchased my home in 1997 for $85,000 (Hardly living beyond my means.) and am not underwater. I currently have substantial equity in it. However, you cannot get a home equity loan when you are on unemployment. I lost my first job of 10 yrs. in May of 2007 and was unemployed until March of 2008. (I had never collected unemployment before and worked hard and saved for many years). During that time I went through my entire savings. I was just laid-off again due to lack of work on Oct. 1st, this time I have NO savings because I had to take a $10 HR. job. I tried to refinance when I had a job; however, I didn’t qualify for the government refinance because I don’t have a Fannie or Freddie loan. I provide my own health ins. and I currently have the property for sale. Your WI-FUR program is exactly what someone like me who continues to fall through the cracks needs to save my home from foreclosure. I think all the people above who are against your program should not accept unemployment (a government handout) if they should loose their jobs since they don’t agree with programs to help those of us who have done everything right our entire life and will loose everything we have because of those who choose not to be responsible. Don’t those against your plan realize that the more homes on the market for sale only brings down the value of their homes and they loose as well??? I hope you are able to get this passed. The last thing this economy needs is more homes on the market for sale because it does effect everyone.