Legal Commentary

On the Obama Mortgage Plan-Becker

By Gary Becker

The housing market is in shambles as home prices continue to fall-so far the average house has fallen over 25 percent in value from its peak. New home construction has virtually stopped. Two causes of the bubble in both housing prices and construction are low interest rates that made durable goods like housing more attractive, and unjustified optimism on the part of both lenders and borrowers that housing prices would continue to rise at a rapid pace. Also of possible importance was the inducements provided banks and other lenders by the Community Reinvestment Act and the 1992 Housing Bill to increase loans to subprime buyers. In 1994 subprime mortgages were under 5 per cent of all mortgages, but by 2006 they were about one-fifth of all mortgages, although the precise roles of this legislation and general optimism about the housing market in the increasing share of subprime mortgages has not been established.

In normal economic times, the housing market would be allowed to continue to work off its excess capital stock through still lower housing prices that increased demand for housing, and minimal levels of new housing construction that reduce the supply of housing. In addition, the government might have retreated from encouraging mortgages to persons with poor credit histories and low earnings. The President's plan is to encourage new housing construction partly by seeking to keep mortgage interest rates low for middle class families taking out new mortgages. To achieve this goal, both the Treasury Department and the Fed will continue to buy mortgage-backed securities from Freddie Mac and Fannie Mae, and Treasury will provide up to $200 billion in capital for this purpose. Likewise, instead of reducing subprime mortgages, the President's plan would stabilize and even increase them by giving lenders financial incentives to reduce interest rates to subprime borrowers, and also by cutting mortgage payments on these loans to no more than 31 percent of borrowers' incomes.

Of course, these are not normal times since we are in the midst of a serious recession that will get worse before it gets better. Does the recession, and the high foreclosure rates on homes, justify these unusual steps that will retard rather than hasten downsizing of the housing market? I do not believe so. Posner shows that the plan has many unattractive features, including that it would be a bureaucratic and administrative nightmare. In addition, it will almost surely cost far more than the $75 billion price tag that the administration attaches to the plan. This magnitude of spending on a complicated housing program seems like a bad idea when so much money is being committed toward other programs to help the economy: about $800 billion in a fiscal stimulus package, and probably much more than that in the Treasury's and the Fed's efforts to help banks become solvent and active in the lending market. I am also worried about increasing Fannie and Freddie's stake in the housing market when their policies have contributed significantly to the excessive sub prime mortgage lending.

In a prior post (see my "On the Obama Stimulus Plan", Jan. 11th, 2008) I expressed my skepticism about how much short term effect on the economy will be produced by the fiscal stimulus package since it mixes long term changes in the economy that will have negligible short term stimulus effects-such as support for alternative energy sources- with helping the economy get out of the recession during the next couple of years. I am more confident that the Fed's policy of lowering interest rates and creating bank reserves through open market operations will succeed in stimulating banks to further increase their lending. I also believe it is necessary to increase the liquidity and capital of some banks, and to close other banks that are no longer viable, although so far the policies to do this advanced by the previous and current Secretaries of Treasury do not seem well thought through.

To return to the housing market, during previous housing busts, banks that were heavily involved in the mortgage market would try to avoid foreclosing on properties during bad times since it was costly for them to take possession of large numbers of houses. They would stretch out mortgage repayments, and even cut the amounts owed in order to help borrowers get through difficult times. That did not prevent sizable increases in foreclosures during highly depressed housing markets, but it did keep the number of foreclosures well below the number of borrowers who experienced difficulty in meeting their payments.

It appears that that the relatively simple decision of lenders to avoid foreclosures is much more difficult when banks and other lenders have sold off the mortgages they originated into mortgage-backed securities that pool mortgages originated by many different lenders. For it is not easy to restructure only the fraction of the mortgages that need restructuring in securities that pool a large number of mortgages. I believe there is a case for making it much easier to restructure mortgages in such securities; indeed, to make this more comparable to the ability to restructure mortgages under the old system when banks held on to the mortgages that they originated.

Full post as published by Becker-Posner Blog on March 01, 2009 (boomark / email).