Remedies for the Housing Market:
A foreclosure problem or an unemployment problem?
26 Jun 2009 in Regulatory Economics
The Obama Administration's program to prevent foreclosures is encountering hurdles. There is new empirical evidence that it is based on an erroneous diagnosis of the problem.
According to Wall Street Journal reporters Ruth Simon and James R. Hagerty, the Administration's program to prevent foreclosures is not working because it is not designed to deal with unemployment as the underlying cause.
Rising unemployment is complicating the Obama administration's effort to reduce foreclosures and stabilize the housing market.
The first wave of mortgage delinquencies was sparked by borrowers who took out subprime mortgages and other risky loans that became unaffordable, causing them to fall behind on their monthly payments. But the current wave is increasingly driven by unemployment or underemployment, economists and housing counselors say.The Obama foreclosure-prevention plan was "built around the subprime crisis model, not the unemployment crisis model," said Michael van Zalingen, director of homeownership services for the nonprofit Neighborhood Housing Services of Chicago.
The Obama program provides financial incentives to mortgage-servicing companies and investors to reduce mortgage-related payments to 31% of monthly income.
The program is based on an assumption that the rise in foreclosures was caused by rising mortgage payments that borrowers could not afford. This was true for mortgages with "teaser" interest rates, such as Option ARMs. 
The Journal's graph, reprinted below, shows that throughout the bursting of the real estate bubble, the default rate among borrowers with Option ARMs has been consistently higher than among other borrower classes, including those with subprime loans. Default may occur because the borrower cannot afford the higher payment once the teaser rate expires. Many such borrowers were speculating that home prices would continue to rise, enabling them to sell at a higher price and earn extraordinary returns on minimal investments. As prices tumbled, in many cases eliminating the borrower's equity, continuing to make payments became an unattractive financial strategy.
The Administration's foreclosure prevention program is based on the assumption that borrowers would choose not to default as long as mortgage payments were limited to 31% of income. From the outset, this program could help only the subset of borrowers who still had salvageable equity despite market price declines, or who had strong nonfinancial reasons for staying in their homes despite lacking equity.
The graph shows that since the program was established, default rates have stopped declining or risen. The program cannot address defaults that are caused by unemployment. Capping mortgage payments at 31% of income cap does not help borrowers who become unemployed, because 31% of zero is still zero.
But many borrowers don't have sufficient income to qualify for a loan modification under the plan. Mr. van Zalingen said roughly 45% of the more than 900 borrowers who sought help at two recent counseling events would fall into that category even if their interest rate were dropped to 2% and their loan term were extended to 40 years.
Many of those unqualified borrowers suffered job losses or a reduction in income, Mr. van Zalingen said. Roughly 27% of borrowers who called the mortgage industry's national "Hope Hotline" in the second quarter of 2009 cited unemployment as the primary or secondary reason for their mortgage problems, up from 9.7% in the second quarter of 2008.
The administration is considering making changes to the loan-modification program to address the current employment landscape."We recognize that unemployment is a significant complicating factor," said Deputy Assistant Treasury Secretary Seth Wheeler. "We are studying what more we can do."
According to Simon and Hagerty, the Administration is considering several options, including permitting borrowers to stop making payments while they look for work or having the government make payments on their behalf. The article notes that developing criteria o decide which borrowers deserve such assistance and which do not is a complex problem. However, it does not include any discussion of potential adverse incentive effects.
