Mortgage Relief: the Principal Writedown Illusion

Both the Bush and Obama administrations have pursued the idea of writedowns of the principal balances of defaulting mortgages as a way of furnishing distressed homeowners relief. About 25% of all mortgages are now underwater. In spite of well over a year of effort, something like a few hundreds of thousands of borrowers, at most, out of the millions in trouble, have received permanent principal writedowns. They may be the most effective way to help struggling owners stay in their homes. They reduce payments to a level that will, long term, hopefully be manageable. At the same time, they keep houses off the foreclosure market, thereby reducing downward pressure on housing prices. If housing prices keep declining, the number of homeowners underwater on their mortgages will increase, thereby producing more pressure to default and repeat the downward cycle. Why, then, have principal writedowns been so strongly resisted by banks?

Here's our take. Fairness isn't the issue. Principal writedowns are unfair, benefiting in many cases the reckless and irresponsible at the expense of the conscientious and taxpaying. But the big banks don't give a rat's big toe about fairness (they didn't seem to have a problem taking a multi-trillion dollar bailout when their survival was on the line). The problem is that they can't dump the bulk of the costs of principal writedowns onto the federal government.

If banks were today to write down all underwater mortgages to the market value of the homes, they'd have to book losses somewhere around $600 billion (with perhaps a couple hundred billion more for federal agencies like Fannie Mae, Freddie Mac and the FHA). The Tier 1 capital (a commonly used measure of bank capital) of the 20 largest banks in the U.S. (which among banks hold the most mortgage assets) is probably in the range of $900 billion. Comprehensive principal writedowns could reduce Tier 1 capital by hundreds of billions and require a major recapitalization binge. The banks' existing shareholders would be displeased, to say the least. In addition, the federal government and the ever accommodative federal taxpayers would probably have to prop the banks up as they returned to the capital markets.

While not every underwater homeowner would seek a principal writedown, the attractiveness of the proposition would likely motivate a lot of people who aren't currently in default to volunteer for a bum's rush out of part of their monthly payments. After all, why pay full freight when the neighbor across street gets a break and comes up with enough cash for an annual vacation? You may recognize the moral ambiguity of not paying a loan you voluntarily undertook. But what will you say when the kids across the street can suddenly afford summer internships in Europe and your kid wants one?

The Obama administration is willing to toss principal writing down banks 10 to 21 cents per dollar written down for their trouble, depending on how far underwater the loan is. But with many loans tens of thousands or even hundreds of thousands of dollars underwater, the 79 to 90 cents on each dollar of write down the banks absorb hits their bottom line hard. Politically coerced changes to the accounting rules last year allow banks to waffle and delay on recognizing loss on mortgages, until they've been sold after foreclosure. It's only after the foreclosure sale that banks have to book a loss. Foreclosure rates have been rising, but banks have been dribbling out foreclosed properties, holding many off the market to prevent a downward price panic. They hope to get more than the current market price for the house, something that wouldn't be possible if they had to do an immediate principal writedown. So it makes more sense to foreclose, hide behind relaxed accounting rules, and hold onto the house while hoping for a better price in the future.

Another reason for waiting, which surely no banker will admit, is that political pressure on the Obama administration to expand the use of principal writedowns will probably grow. Just two weeks ago, the administration announced the 10 to 21 cents on the dollar offer. As the mid-term election approaches, those terms could improve. No administration, Democrat or Republican, has ever done anything except protect and advance the interests of homeowners and the housing industry. Even the Bush Administration's nationalizations of Fannie Mae and Freddie Mac only further entrenched those institutions' comprehensive grip on housing finance. The Obama administration may well up its bid before this fall's elections. And if it doesn't, the banks are under no additional pressure than what they face now--a moribund real estate market, but no need under the accounting rules to recognize that reality--to offer principal writedowns. It makes sense for the banks to stall and delay, until the feds to come through with more dinero.

Since the 1930s, housing has been a federal program, not a market. It doesn't operate in accord with market principles, and market forces in housing operate spasmodically and unpredictably. Struggling homeowners realistically have few or no good options. Potential buyers are mystified by a market where nothing makes sense. Transaction costs are indefensibly high, and closing processes are tortuous enough to extract full confessions from the most hard core terrorists. Because the real estate market isn't truly functional, the huge overhang of bad loans from the early and mid-2000s hasn't cleared the market, and we muddle along even after years of loss and stagnation. If you're going to buy a house, save up a big downpayment and buy only as much as you need. Good luck.