The Not-Quite Bailout
By Justin Fox
Barney Frank is on the line. I ask the Massachusetts Democrat, who chairs the House Financial Services Committee, if he thinks the housing bill that he and Senator Chris Dodd are on the verge of pushing through Congress will really do much good. Frank first trots out a joke from the late comedian Henny Youngman: "How's your wife?" Answer: "Compared to what?" Then he gets a bit more serious. "Do I think it's gonna have a great impact?" he says. "It's gonna have an impact. I think it will be helpful."
It's not the most rousing endorsement. But it's probably a fair assessment, at least for the centerpiece of the sprawling legislation--a plan to use the insurance guarantees of the Federal Housing Administration (FHA) to entice lenders to renegotiate up to $300 billion in troubled home loans. It might do some good, and the fact that Frank can't bring himself to say more may have less to do with the legislation itself than with the immensity of the problem Congress is trying to address.
The problem is that, from 2003 through 2006, mortgage lenders extended trillions of dollars in loans that they never should have made, driving house prices to unsustainable levels in many areas. Now millions of borrowers can't make their payments, prices are plunging, and the global financial system is finding out how dependent it had become on dodgy U.S. mortgages.
This correction process--in which both homeowners and lenders eat losses on their investments--can't be stopped entirely. It shouldn't be stopped, and going forward, a major priority for regulators will be averting such lending binges--as new, tougher mortgage rules from the Federal Reserve aim to do. But at the same time, many on Wall Street and in Washington fear that the correction could careen into an economic cataclysm. That's why the Fed has intervened at the top of the financial food chain by cutting interest rates and bankrolling a shotgun takeover of the investment bank Bear Stearns. And it's why there's been lots of talk in Washington about doing something--anything--to slow the tide of mortgage foreclosures.
About 3 million homeowners will default this year on their mortgages (the first step in the foreclosure process), forecasts Moody's Economy.com That's double last year's number and amounts to 6% of all U.S. mortgages. The fear is that mass foreclosures could accelerate price declines, bringing on a cascade of additional foreclosures and economic trouble in their wake. "I get this sense in an increasing number of markets around the country that this death spiral is developing," says Mark Zandi, chief economist of Moody's Economy.com and an outspoken advocate of doing more to combat foreclosures.
Up to now, the main such effort has been a voluntary deal announced last December by Treasury Secretary Hank Paulson in which mortgage lenders agreed to freeze interest rates for certain subprime borrowers. But thanks to the Fed, high rates on adjustable-rate loans are no longer the big problem. The big problem is that 9 million U.S. homeowners owe more than their houses are worth; they're upside down, in the parlance, meaning that if foreclosures are to be slowed, the mortgages themselves must shrink.
Lenders often agree to loan modifications when borrowers run into trouble--one industry group says 315,000 home loans were modified in the first five months of this year. The Dodd-Frank plan aims to increase that number with help from the FHA. The agency would insure existing loans in which a) the lender forgives at least 10% of the debt and switches to a fixed rate and b) the borrower agrees to split any sale gains with the FHA.
This balancing act keeps the plan from being an outright bailout for either lenders or borrowers. But it also limits the likely uptake. The Congressional Budget Office (CBO) has made two estimates--one projects that 500,000 loans would be converted over the three-year life of the program, and the other projects 400,000. If that range proves correct, the plan wouldn't cost taxpayers much; the CBO estimates $729 million to $1.7 billion, depending on the uptake. By contrast, the Defense Department spends about $2 billion a week in Iraq.
If house prices keep falling, the cost of the program could rise--but would probably be dwarfed by other spending to combat the crisis. A worst-case taxpayer bailout of mortgage-market giants Fannie Mae and Freddie Mac, whose plummeting stock prices caused consternation in early June, could cost as much as $1.1 trillion, according to Standard & Poor's. Which brings us back to the big question: Would a law that helps a few hundred thousand homeowners avoid foreclosure really have an impact on house prices? Well, compared to what?
Extra Money To read Justin Fox's daily take on business and the economy, go to time.com/curiouscapitalist