Martin Feldstein on the Housing spiral
Martin Feldstein pens a comment on the dangers of overshooting on the way down in housing in this morning's FT. Martin is a professor of economics at Harvard and also apparently an avid reader of this blog since I wrote about a 20% overshoot as a game-over scenario. He has taken notice :)
House prices that could overshoot by 60 per cent on the way up could also overshoot substantially on the way down. During the past 12 months, house prices across the nation fell by an average of 16 per cent.
A policy is needed that will permit the appropriate 15 per cent additional decline in house prices but end the risk of a further downward spiral. No such policy is now in place or on the legislative drawing board.
Because of the uncertain values of mortgage-backed securities, financial institutions lack confidence in the liquidity and solvency of counterparties and even in the value of their own capital. Without that confidence, there cannot be adequate credit flows and without credit there cannot be economic activity and growth.
Because of the decline in house prices that has already occurred, more than 10m home owners now have mortgages that exceed the values of their house. This is 20 per cent of all homeowners with mortgages. For half of that negative equity group, the debt exceeds the house value by more than 20 per cent. If house prices fall another 15 per cent, negative equity mortgages will rise to 20m.
The large and growing number of homeowners with negative equity will increase the rate of defaults and foreclosures and therefore drive the downward spiral of prices. Defaults are likely to accelerate as the ratio of the debt to the home value rises. While a homeowner who owes 10 per cent more than the value of a house may continue to service the mortgage, when the excess debt reaches 30 per cent he is much more likely to default. Each such default puts downward pressure on existing prices, increasing the likelihood of further defaults. It is this spiral that threatens the American economy and the global financial system.
The federal government would offer every homeowner with a mortgage the opportunity to replace 20 per cent of that mortgage with a low interest government loan – up to a loan limit of $80,000 (€55,000, £44,000) – that reflects the government’s lower borrowing rate. Creditors would be required to accept this partial mortgage pay-down and to reduce the monthly interest and principal by the same 20 per cent. That mortgage replacement loan would not be collateralised by the house but would be a loan that the government could enforce by lodging a claim on an individual who does not pay.
With the mortgage replacement loan, people who now have a mortgage equal to 90 per cent of their house value would see that mortgage fall to just 72 per cent of the house value, implying that it would take a very unlikely price fall of more than 28 per cent to push those individuals into negative equity.
By stopping the downward overshooting of house prices, the mortgage replacement programme would help all homeowners, including those who now have negative equity. Limiting the destruction of homeowners’ wealth would help to maintain consumer spending, boosting production and employment. Renters as well as homeowners would benefit. And stabilising the values of mortgage-backed securities would strengthen financial institutions, increasing credit flows that would further stimulate the economy.
The US economy is sliding into recession. Employment, industrial production and real incomes are declining. Monetary policy has little traction because of the dysfunctional credit markets and the collapse of housing. The fiscal policy of tax rebates failed to achieve a significant impact on consumer spending. The economy will continue to decline and the financial markets to deteriorate unless a policy is adopted to stop the downward spiral of house prices.
This looks like is a refinancing program by the govt. I do not exactly understand how this reduces and individual's equity participation. You owe the same monies but now your creditors are a private company and the govt and the govt one happens to have a lower payment rate. You will still go in negative equity territory but you have swapped a no-recourse loan into one where the govt can go and pick your pockets. Also in case there is nothing to pick the tax payer is left with the bill. This helps the lenders, by liquifying 20% of the value, they get the cash now, which they badly need. This helps Wall Street but not Joe Schmoe.