The Frank/Dodd housing proposal, while not law yet, looks to be headed there. While it seems the proposal will have some non-zero impact on the housing market, I'd vote against it. Quickly, here are my problems with the proposal:
- The key element is that the government will trade a GNMA security for a troubled loan as long as the bank holding the loan agrees to write down the principal to 85% of the assessed value of the home. This could be a very large write down in many cases. Say I bought a $300,000 home at the peak and put 5% down. Let's say the appraised value has fallen by 15%, so the house is worth $255,000. Now the bank has to write the loan down to 85% of that ($216,750) in order to participate in the Frank/Dodd program. What started out as a $285,000 loan must be written down by $68,250, or 24% of the original loan amount. Banks are going to be very reluctant to participate in this program. Why not roll the dice and hope that the borrower keeps paying?
- Given the above, any loan the bank does decide to put into the GNMA program will be of the truly toxic waste variety. So tax payer costs will be significant.
- Even if the proposal were to be signed into law today, most analysts agree that the book on 2008 foreclosures is already written. The foreclosure process is always a lengthy one, and currently servicers are swamped, so its taking longer than usual. So the proposal won't start having an impact until 2009.
- By that time, we'll be nearing a "burn out" on bad mortgage foreclosures. By this I mean, at some point, all the really bad loans from the 2005-2007 period that are going to default will have defaulted. By mid-2009, it will have been two full years since the sub-prime blowups started. That should be enough time for the overwhelming majority of the loans to borrowers who really can't afford the loan to be ferreted out. From that point on, loan foreclosures will probably be above average for a while because of the lack of equity, but the pace should decline.
- By early 2009, homes in the most bubblicious areas will be down 25-40%. So the amount banks have to write down to stick these loans to the government will be very large indeed. The risk/reward may be to retain the loans and hope that most of your borrowers keep paying, or to work out a separate modification rather than participate in the Frank/Dodd program.
- Put the last three points together, and most banks will figure they've already foreclosed on the properties they might have originally put into the Frank/Dodd program, and what remains is worth keeping.
- I'm not even mentioning the obvious moral hazard, which is another issue entirely.
So this housing proposal, at least as far as helping home owners, is a lot of political posturing without much eventual impact. So I'd vote against it.
What kind of government intervention might actually work? What the housing market needs is a reduction in supply. We're slowly getting to a place where new construction isn't so much a problem, but as I've alluded to above, I think we're about a year to 18-months away from the peak in foreclosures. So that's going to remain a problem.
Normal household formation won't soak up the supply for a while. A recent report from Lehman Brothers indicated that there will be 4 million units which need to be absorbed by the end of 2009, both foreclosures and new home construction. About 1 million can be taken down by normal household formation. That leaves 3 million homes to sell, a pretty big nut to crack.
Demand could come from either current renters becoming home owners or investors. In both cases, prices need to drop a large degree to stimulate demand for 3 million marginal homes. For what its worth, the Frank/Dodd proposal is estimated to help 500,000 home owners. That still leaves a pretty big nut to crack!
There is actually a relatively simple way for the government to help soak up this demand quickly. Make investing in a home more attractive. In other words, make buying a foreclosed property for the purpose of renting it out a more attractive investment. It could work any number of ways: there could be a large tax rebate to the investor, FHA could offer cheap loans, etc.
It could even be structured such that the financial system was strengthened in the process. Say the government allowed anyone who bought a foreclosed property to write off 20% of the purchase price on their taxes, but in order to qualify, the buyer has to have at least 20% equity in the home. The result would be a deleveraged housing sector. Most alternative proposals involve the government helping to provide down payments. But that doesn't deleverage anything, only shifts the leverage to the government.
Anyway, my idea is politically untenable, since it would help wealthy investors make money on the back of a displaced homeowner. So it isn't likely to happen. There have been similar programs enacted in urban areas, under the auspices of reducing urban blight. So it might be that some local municipal housing agencies attempt such a thing.
By the way, while I doubt the Frank/Dodd proposal helps much in terms of housing prices, it probably will help in terms of certain sub-prime securities. As I said above, banks will most likely transfer the worst of their loans to FHA under the proposal, i.e., the ones they securitized. Most of the A and BBB-rated sub-prime bonds from 2005-2007 are toast anyway, but the senior stuff trading at 50% of par could see some significant benefit. Too bad it'll be too late for Ambac and MBIA...