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Insufficient Boldness

In the fall of 2007, the Bush Administration had a chance to stop the housing crisis before it would’ve reached the point of being called a crisis. The writing was already on the wall of every foreclosed property, and outside experts articulated workable versions of exactly the kind of scheme announced today by the Obama administration. But with its strong ideological preference for “market”-based solutions and its reluctance to ruffle financial sector feathers, the Paulson team preferred a voluntary loan modification program that proved almost completely ineffectual. You know the rest of the story.

At last, President Obama’s housing plan starts us down a more pragmatic road. But is this comprehensive program--which could have been decisive 18 or even six months ago--sufficiently aggressive to make a difference now?

Before we get into the plan’s specifics, it’s important to know that there is a clear case to be made for using taxpayer money to reduce the number of foreclosures and help homeowners refinance their mortgages. On the negative side, foreclosures destroy economic value in several ways: transaction costs of foreclosure itself; reduced value of foreclosed houses and impact on houses in the neighborhood; reduced property taxes for local governments; and increased crime due to vacant houses. The death spiral of foreclosure-forced sales, falling house prices, and further foreclosures needs to be broken.

On the positive side, reducing the number of foreclosures will help support prices of mortgage-backed securities. Enabling homeowners to refinance into mortgages with lower monthly payments also increases disposable income and overall economic activity.

But, as with the banking crisis--which, too, will require taxpayer money in one form or another--the question is what form that assistance should take.

One of the strong points of the plan is that it attempts to assist both homeowners at risk of foreclosure and homeowners who are not at risk of foreclosure, but are constrained by high mortgage payments. For the former group, the program combines cash incentives for lenders to modify loans with additional cash incentives for borrowers. However, whether or not to modify a loan remains subject to lender discretion, and it is impossible to say whether the incentives will be sufficient to get the lenders to loosen up the way they should. There is also relatively little insurance on offer for modified loans outside the Fannie/Freddie safety net.

Still, a definite advantage of the plan is that it should help unblock the problem of securitization trusts. Housing loans that were “bundled” together into mortgage-backed securities have been hard to restructure, because no one has clear authority to negotiate on behalf of thousands of dispersed investors, particularly when there were multiple tranches or complex structures. For loans that have been securitized, the loan servicers who administer the mortgage can now be pressed by their regulators to modify loans. The proposed coordinated approach by regulators on this issue is long overdue.

The plan also offers meaningful assistance to those not immediately facing foreclosure, primarily by allowing people to borrow more (relative to the value of their house) when refinancing into lower-rate government-backed mortgages. Effectively, it is now easier to qualify for a refinancing, and that should leave homeowners with more available income for consumption (or saving). At the same time, substantial additional money will increase the capacity of Fannie and Freddie to buy mortgages, which theoretically will increase liquidity and reduce mortgage rates. However, the plan represents a step back from the more ambitious proposals to force mortgage rates down by guaranteeing Fannie/Freddie debt (Krugman) or funneling low-rate funding from Treasury to Fannie/Freddie (Hubbard and Mayer), or offering direct government mortgages (Feldstein).

The Obama plan is certainly better than the inaction that preceded it, and it signals that some unproductive ideology has quietly dropped away. Unfortunately, it feels like being vaccinated only after already contracting a disease; you would much rather be offered a potential cure. That cure would be expensive--particularly if it involved more money to support the modification of non-Fannie/Freddie mortgages--and it might not work. But there is little to be gained at this stage from being insufficiently bold.

Simon Johnson is a Professor at MIT Sloan School of Management and a Senior Fellow at the Peterson Institute for International Economics. He is co-founder of the global economy website,

By Simon Johnson