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Dean Baker

Dean Baker is co-director of the Center for Economic and Policy Research

December 1st, 2009 11:55 AM

Mortgage Modification: Bank Bailouts By Another Name?

The big talk in Washington these days is "helping homeowners." Unfortunately, what passes for help to homeowners in the capitol might look more like handing out money to banks anywhere else.

The basic story is fairly simple. Tens of millions of US homeowners are now underwater: they owe more on their mortgage than the market value of their home. The reason is that they bought homes at bubble-inflated prices earlier in the decade. Economists and other policy wonks insisted that housing was a great buy, even as house prices got ever more out-of-line with economic fundamentals.

Needless to say, the Wall Street crew was eager to cash in on the mania, peddling deceptive mortgages and reselling mortgage-backed securities all over the world. These deceptive mortgages have now "reset" to higher interest rates, leaving many people unable to afford their mortgage payments. However, even at lower interest rates, homeowners who purchased houses at bubble-inflated prices would find themselves paying far more for their homes than they would to rent a comparable house.

As a result, these homeowners are effectively throwing money away every time they make their monthly mortgage repayment. They would be much better off renting the same house and putting the savings in a retirement account or some other form of investment.

The gaps between mortgage payments and rent can often be quite large. A study that we put out at the Center for Economic and Policy Research calculated a family that purchased a small home in Los Angeles near the peak of the bubble could save $1,640 a month by renting rather than owning. This comes to almost $20,000 a year. In Phoenix a family who purchased a home near the peak of the bubble could save $420 a month or $5,000 a year. In Miami the savings would be $1,940 a month, more than $23,000 a year.

These homeowners also have no reasonable prospect of ever getting equity in their homes. In many cases they are 20% or 30% underwater, possibly owing $100,000 more than the current value of their house. Many of the people who never saw the housing bubble are arguing that house prices will return to their bubble peaks. No doubt, these people also expect a resurgence of the internet stocks of the late 1990s.

In reality, there continues to be an enormous over-supply of housing as reflected by the record vacancy rate. This huge over-supply is causing nominal rents to actually decline for the first time ever. Once the homebuyers' tax credit and other extraordinary subsidies end, house prices will resume falling to bring supply and demand into balance.

In this context, it is extremely unlikely that the vast majority of underwater homeowners will ever accumulate a penny in equity. Keeping them in their homes as owners means wasting thousands of dollars a year on excess housing costs only to be forced to arrange a short sale or face a foreclosure at some future point in time.

So, who benefits from "helping homeowners" in this story? Naturally the big beneficiaries are the banks. If the government pays for a mortgage modification where the homeowner is still paying more for the mortgage than they would for rent, then the bank gets a big gift from the government, but the homeowner is still coming out behind.

In some cases the government may pay enough to buy down principle that the homeowner is no longer underwater, but the bulk of this money is a gift to the bank, not the homeowner. If a homeowner is $100,000 underwater and the government pays the bank $50,000 to write the loan down to the current value of the house, then the bank has pocketed $50,000, while the homeowner is essentially left breaking even. This is very generous to the bank, but homeowners have nothing to show in this story.

President Obama has proposed putting up $70bn to help homeowners in this way. This help for homeowners is likely to end up as a larger subsidy to the banks than the rest of the troubled asset relief programme (Tarp). The reason is that the rest of the Tarp programme was a loan. The loans were at below market interest rates - thereby providing a subsidy to the banks - but most of the money is getting paid back.

The original batch of lending to banks was $250bn. Even if we assume an average interest rate subsidy of 10 percentage points (a very large subsidy), this still implies that the lending portion of Tarp only handed $25 billion to the banks, far less than the $70 billion that we are prepared to hand them under the guise of helping homeowners.

There are simple, low-cost ways to help homeowners who were victims of the housing bubble and lending sharks. The most obvious way would be to give homeowner the right to rent their home at the market price for the next decade. But this would mean hurting the banks rather than giving them taxpayer dollars, and we still don't talk about hurting banks in Washington DC.

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