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Sizing Up The Housing Plan

There are two key proposals at the center of Obama's housing plan: one for people still making payments; one for people who've stopped making payments or are about to. Obama would help the first group refinance at a lower interest rate. For the second group, he'd give lenders incentives to accept less money each month than they're currently owed. I can think of two plausible objections--one macro, the other micro. But there are reasonable responses to both.  

First, one of the fairer criticisms of the plan is that it's overly incrementalist--that it only targets a subset of the mortgages that are underwater (that is, the owner owes more on the mortgage than the house is worth), and therefore leaves the housing market vulnerable to a big wave of defaults down the road. (If your mortgage is underwater, and you don't expect the value to recover any time soon, it may be rational to just ditch it since you can't get out by selling or refinancing.) The Times' David Leonhardt made the most lucid version of this critique on Wednesday:

In a handful of metropolitan areas, including Phoenix, prices have fallen almost 50 percent from their 2006 peak.

Homeowners in such places may wonder if their houses will ever be worth more than their mortgages. So fairly small changes in their lives — like a reduction in work hours or the breakdown of a car — may lead them to walk away from their homes.

“I would not minimize that risk at all,” said Frederic Mishkin, a member of the Fed’s board of governors until last year.

If even 10 percent of the underwater homeowners walked away, Mr. Mishkin notes, foreclosures would soar, exacerbating the economy’s many problems.

Other economists who share his view are calling for across-the-board programs that would reduce interest rates or otherwise juice the housing market. They are worried that without bolder government actions, the housing market will continue to spiral downward.

In fact, you could really level this critique at all of Obama's economic plans to date--the stimulus may be too small to fill the $2 trillion output gap we're facing over the next two years, and the bank bailout is probably too small to fill the $1- to $2-trillion balance sheet hole in the banking sector. In each case, the administration is probably going to have to go back to Congress for more money.

But while I think there's a strong case to be made that Obama should have asked for more out of the gate on all three fronts, in reality, Congress was never going to give him everything he wanted. And if I had to choose the one area where I thought he could get away with a little less, housing would probably be it.

For one thing, as Leonhardt notes, people--for whatever reason--often continue making payments on their houses for years and years after their mortgages go underwater. So it's not delusional to bet on this continuing. (Whereas I think there's no plausible scenario in which we won't need more money for the banks than we've set aside.*) For another, the political dynamic here is really tricky. If you help out too many people who are still making payments (which basically means you subsidize their refinancing), you get hammered for a gratuitous giveaway.

Finally, the costs can pile up very quickly once you go beyond a certain number of underwater mortgages. In his speech, Obama noted that "the estimated cost to taxpayers would be roughly zero [from these subsidized refinancings]. While Fannie and Freddie would receive less money in payments, this would be balanced out by a reduction in defaults and foreclosures." I'm not sure if that's exactly right. But I suspect the cost is pretty low. That's probably not the case once you move on to more and more underwater loans.

So, all in all, I think this is a decent gamble by the administration.

As for the micro point, it relates to the work-out portion of the plan, in which the administration provides subsidies to lenders and loan-servicers to lower mortgage payments for people at risk of defaulting. One question on a lot of people's minds is: Isn't it in the lenders' interest to do this even without the subsidy, since they'll end up making more money by lowering the mortgage payment than they'd make if they had to foreclose? And if it is in their interest, why are we subsidizing them?

The short answer, which FDIC Chairman Sheila Bair gave at a briefing for reporters today, is: "We tried voluntary. It didn't work." The longer answer, from what I can tell, is that there's what economists call a principal-agent problem. That is, it may be in the lenders' (aka investors') interest to do this. (In fact, Bair suggested that IndyMac, a big investor in mortgages, which the government now runs, nets $50,000 for every loan it modifies because foreclosures are so costly.) But, given all the slicing and dicing of mortgages that's gone on over the last few years, investors often own small bits and pieces of a lot of different mortgages, not whole mortgages. Since it would be very difficult to get them all together to agree on some loan modification, the loan servicer (a different company which has no skin in the game but collects payments for all the investors) is the one that ends up making the decision. And often the decision is no, because they don't get anything out of it. So, unfortunately, the subsidies are necessary.

*There may be sound political reasons for not asking for more TARP money just yet. But I don't know anyone who doesn't think we won't need more.

--Noam Scheiber