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Monday, November 10, 2008

Are Mass Foreclosures the Worst Thing That Can Happen?

Turn on any business related show and you are likely to hear some pundit or so called expert bemoan the potential for mass foreclosures and proclaim that the government must do everything in its power to avoid such a scenario. To pundits and experts like this, mass foreclosures is the worst case scenario to be avoided at all costs. Is this really so?

First, mass foreclosures is the end result of a different problem, mass unqualified borrowers getting loans they can't afford. To avoid foreclosures at all costs is like a lifetime smoker avoiding a heart transplant at all costs. With or without these foreclosures, the underlying problem will remain, large quantities of unqualified borrowers. Some, most namely John McCain, have proposed a reincarnation of the FDR era Homeowner's Loan Corporation. Under such a plan, the government would take over loans from troubled borrowers and provide them with terms they could afford. In fact, FDR's name and policies have often been mentioned in dealing with this crisis. That is unfortunate because in fact, FDR's original policies were, in my opinion, totally ineffective in dealing with the original depression. Eight years after taking office the unemployment rate continued to be just over 10%. We were still in the middle of a depression after two terms of FDR big government policies. Had we not entered WWII, it's unclear when our country would have gotten out of the depression.

Now, some would like the federal government to reinvent the New Deal and the reincarnation of the Homeowner's Loan Corporation is just one of the ways. There are two ways to look at the situation. One way is to see these borrowers as patently an unqualified who desperately need to be removed from the housing market immediately. Another way to look at it is to see these borrowers as generally qualified who had the misfortune of getting into a loan they can't afford. If you believe in the latter, you also likely believe in something like the HOLC, loan modifications, foreclosure moratoriums, and other measures to provide these borrowers with loans they can't get. Those that believe as such must come to grips with this question though. If these borrowers are really in fact qualified why are they in a loan they can't afford? If you believe the latter and expect government to do something about it, then you are taking a massive multi hundred Dollar gamble with tax payer money. If you are wrong, then it will be the government stuck with these bad loans. There is no bailout of a bailout. The government will have to go in and foreclose on these folks.

I am of the opinion that a mass foreclosure will act as a sort of cleansing of the real estate market. There is no doubt that mass foreclosures will devastate real estate prices, but that devastation will be temporary, and once its over, then we will all know we have hit bottom. Then, all of these irresponsible borrowers will be removed and the real estate market will have only those qualified to be in it.

I believe that for the most part these borrowers are simply irresponsible. They got into loans they couldn't afford, and saving them from themselves with new loans that would in effect reward their irresponsibility. This will only encourage these folks to just spend lavishly again. Only, once they get themselves into trouble the next time they will be holding onto government loans.

Think of this with this metaphor. If you have a big bandage covering a huge bruise, you can take it off one of two ways. You can either rip it off quickly and have it hurt immensely for a short period of time, or you can take it off slowly and have it hurt a little for a very long time. I would rather pull the bandage off really quickly. I would rather take whatever pain we have in store and get it done with. The real problem is that saving borrowers may work temporarily. If it is done at the right time, it might even appear to be working just in time for the 2010 election. All those that implement such a plan would likely be rewarded in those elections. Yet, the day of reckoning would come eventually. When that day comes though, it will be a disaster that will make what is happening now seem very mild.


Anonymous said...

It’s difficult for me to accept the concept that massive foreclosures is the best solution to the housing crisis. You can’t be serious! Apparently you don’t own a home. After all, that approach is going to impact many people who had nothing to do with the problem, people who were responsible borrowers and paid their bills. What if a responsible homeowner wants to move to a different city to take a better job? Their equity may well be upside down, especially if they bought their home in recent years. Isn’t it more appropriate to try to stabilize home prices, and even help some of the people facing foreclosure? After all lending policies at many banks contributed to this situation, not simply irresponsible borrowers. The average Joe doesn’t have an economics degree … they trust banks and political leaders who encourage home ownership.

Summarized below are two proposals for addressing the foreclosure problem, and helping the banks (and every homeowner) by stabilizing home prices. The first step is to pursue Proposal 1 and, if it doesn’t work for the homeowner, the last resort is Proposal 2. If both proposals can’t be implemented, then perhaps neither should. But this is a crisis … why not both? We need to help, as much as possible, people facing foreclosure, the banks, and every regular homeowner.

Proposal 1:
This proposal DIRECTLY addresses the plight of Americans impacted by foreclosure. The concept is to move people who may soon lose their homes (or have already) into another foreclosed home they can afford.

To make this happen, the banking industry in areas with high rates of foreclosure (such as many communities in Florida, California, and Nevada) would form local review committees. Federal, state, or local government can provide “limited” support and oversight to these committees, as discussed later.

Each committee would compile a consolidated list of foreclosed, abandoned, and mortgage default homes in their area. Homeowners who have lost (or may lose) their homes would be contacted and, with their input, a decision made as to a monthly payment they CAN afford, and the size/type/location of a home that meets their needs. Based on this information the committee would search for an existing foreclosed home that meets the criteria. Obviously this will be a lower priced home, with a lower monthly payment, property taxes, etc. The homeowner would be shown the home (or homes, if more than one).

At this point the homeowner has two options. The homeowner controls what happens. They can proceed with a foreclosure on their current home, or agree to move to a new home and assume a new, lower cost, mortgage.

There are a variety of ways committee members can encourage people to move to a lower cost home including: (1) allowing the homeowner to transfer the equity (paid down principal) accumulated on their old home to the new home, (2) subsidizing all or part of the moving cost, and (3) telling homeowners that moving (versus foreclosure) will preserve their credit rating plus allowing them to continue enjoying the many benefits of home ownership.

Proposal 1 enables banks to establish a new mortgage approximating the original mortgage on the 2nd home, substantially reducing bank losses versus selling the house to an investor in today’s depressed housing market. Banks also have the option of folding unpaid house payments on the original home into the new mortgage, spreading the payback over many years. Banks clearly have a vested interest in making Proposal 1 work, versus Proposal 2. Proposal 1 should be pursued before Proposal 2. Banks will control the homes released for sale under Proposal 2.

From the homeowner perspective, their new mortgage will probably exceed the actual market value of the home in today’s market. This should not concern the homeowner because (1) they avoided damaging their credit, (2) can live in a home they can afford, (3) will likely (over time) see the value of their new home increase, and (4) after foreclosure, it may be years before they can purchase another home due to credit damage.

Note: This proposal requires no change in the tax laws, or any other laws I can think of. But I do believe government can play a positive role. Government oversight on this proposal should restrict the use of an ARM, excessive home equity lending, interest only mortgage payments, and other discredited lending practices. They can also mediate the natural competitiveness between banking companies, who may find it difficult to cooperate in resolving this crisis because banks with the highest foreclosure rates will benefit the most from this plan.

Note: Mortgage payments for homeowners in trouble should not simply be reduced, even temporarily. This approach is not fair to their neighbors who continue to meet their mortgage obligation, and is the reason many oppose the concept of a “bailout”. Proposal 1 avoids this criticism.

Proposal 2:
Reduce or eliminate capital gain taxes on homes purchased by investors as rentals. The exemption should be limited specifically to foreclosed homes (held by banks). It should not include regular residential home sales and the sale of rentals such as apartment houses, duplexes, and investor owned home rentals. Changing the law will spur private investors to purchase the glut of vacant homes that burden the banking industry. The proposal is relatively easy to implement … a minor change in the tax code (which already exempts most primary resident homeowners). I believe this proposal might even be supported by the banking industry (even though most foreclosed homes would be sold at a loss to the banks) because it will help stabilize declining home prices … a serious concern of the banks. This is a temporary “fix” and should be implemented in phases … such as a 100% exemption the first six months, a 75% exemption the next six months, and so on until the exemption is phased out. For example, an investor who buys a foreclosed home within six months of the exemption taking effect, would owe zero capital gains when they sell the home years later. Phasing will spur investors to act promptly, helping reduce the glut of vacant homes quickly rather than taking years.

mike volpe said...

I like proposal two however that isn't going to save any borrower from being foreclosed on.

Proposal 1 is totally ridiculous. Moving people into a new home is not only a wildly new government intervention but who would give these folks a new loan.

Mortgages are specifically not "assumable" as you want. They certainly wouldn't be "assumable" by someone who is also in foreclosure.

More than that, most of these folks would simply get themselves into trouble in the new home.

What you are essentially offering is to rearrange a bunch of folks in foreclosure and play musical chairs with where they live.

That doesn't save anyone. All it does is mask the problem. Now, someone in foreclosure moves into another home that was also in foreclosure and takes over a new loan. What exactly do you think this person will do in the new loan? My guess is soon enough they will get in trouble again. They are, after all, irresponsible.

Mike Y2KLeader said...

Forclusures are the BEST thing to happen. The price of homes are so high in the first place because banks have made it easy to make loans, thus the price of the homes increased, causing the banks to extend the loans over a longer period of time so the buyers could afford the inflated prices, and in turn the prices kept going higher causing a home that should sell for $5000 to be sold for $200,000. Thomas Jefferson sayd, "If we ever allow banking institutions to take over our country, they will be a worse enemy than any standing army." At what point did America start thinking that we need debt and credit to live?

The solution:
Declare war on credit and the banks, not with guns and violence, but by not giving them our money. Think about it -- if you stop paying your mortgage for six months, you can afford to buy a foreclosure. Why spend 30 years working hard to the bank to acheive your dream of owning your own home? Yes, people who own homes or already invested a lot in their home will now have a home that is worth far less money, but so what? People need a place to live. A home should not be an investment, it should be a home to live in, to provide shelter and a safe haven for your family.

If people don't have to pay for where they live, they will spend money on other things. The money would go back to the economy instead of to the banks.