Friday, July 27, 2012

The Merkley Plan: Big Thumbs Up

Here is Merkley doing his best Austan Goolsbee impersonation - not bad actually.

Imagine that, back in 2006, you and a mortgage company took a joint bet on the housing market.  You entered into a contract for a relatively low down payment in exchange for a high interest rate.  Both sides figured that within a few years the appreciation of the asset would allow refinancing at a lower rate.  This contract worked well for both sides, the mortgage company benefitted from the high payments for a few years and the homebuyer was able to buy a house otherwise unavailable to them.

In fact, I did precisely this when I bought my house in Denver.  I obtained a then novel interest-only loan which allowed me to afford the house initially.  Two years later I was in a conventional 30 year fixed mortgage.

But of course this is all predicated on the asset appreciating. What we have now are a bunch of high-interest mortgages that are underwater and thus without hope of refinancing.  The rub is that refinancing works for everyone - banks benefit because being paid back on the full value of the asset is a lot better than a short-sale and homeowners benefit through lower payments.

So now we have the plan proposed by Oregon Senator Jeff Merkley and that would facilitate exactly this exchange.  Here is Felix Salmon describing it in his blog:

Merkley’s plan ... doesn’t come with any moral hazard problems attached: indeed, at the margin, it encourages homeowners to stay current on their loans, rather than defaulting on them.

The basic idea’s very simple: the government will buy, at par, any new underwater mortgage written on certain terms. So if you currently have a $240,000 mortgage on which you’re paying 8% interest, but your house is only worth $200,000 and you can’t refinance, then suddenly now you can refinance. In fact, you have three options. You can get a $240,000 15-year mortgage at 4%, which keeps your payments roughly the same, but which gets you paying down principal quickly, so that you should be above water in about three years. You can get a $240,000 30-year mortgage at 5%, which cuts your monthly payments substantially. And there’s a third option I don’t fully understand, which includes a $190,000 first mortgage at 5% and a $50,000 second mortgage with a five-year grace period; on that one, monthly payments, at least for the first five years, drop even further.

In many ways, if you don’t sell your house, this is functionally equivalent to a principal reduction. That $240,000 15-year mortgage at 4%, for instance, has exactly the same cashflow characteristics as a $198,000 15-year mortgage at 7%. And the $240,000 30-year mortgage at 5%, similarly, asks homeowners to pay exactly the same as they would if they had a $193,00 30-year mortgage at 7%.

Of course the government can do this because it can borrow money at virtually zero interest and it should do this because a moribund housing market hurts everyone through the drag on the economy. There is risk, of course, and there will be default which will make lots of great anecdotal stories about how the government is foolish, but I suspect that the US taxpayer will still come out far ahead.

One question that remains in my mind is: as are talking about subsidizing homeowners who are not delinquent ?re we really helping the housing market? I suspect many of the 'underwater' mortgages that are still current will remain this way. It is really the delinquent mortgages that are at risk of default. But something is better than nothing and this at least will ease income constraints for households.

The same holds true for the bank side: if these are high interest loans on an undervalued asset and yet they are still current - what could be better? You don't want to give up these loans. So I suspect some push-back from the banks and it will be interesting to see how the political winds blow. But, overall, kudos to Merkley for a sensible plan that addresses a real problem in housing right now in a measured and reasonable way.

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