Academic journal article Federal Reserve Bank of St. Louis Review

How Home Loan Modification through the 60/40 Plan Can Save the Housing Sector

Academic journal article Federal Reserve Bank of St. Louis Review

How Home Loan Modification through the 60/40 Plan Can Save the Housing Sector

Article excerpt

Many well-respected economists have suggested plans for mortgage restructuring built on the idea of share appreciation mortgages, which generate rather complex transactions with conflicting interests between the lender and the homeowner. The 60/40 Plan, however, combines several economic principles adapted to the nature of home loans and appears to provide all the benefits but fewer of the drawbacks of many of these programs, including current government programs such as the Home Affordable Refinance (HARP) and Home Affordable Modification (HAMP) programs. For example, HARP homeowners must service the entire principal balance and meet additional eligibility restrictions that are not warranted by economic considerations. In contrast, the 60/40 Plan provides for affordable monthly payments by restructuring the debt into two parts, has relatively minor eligibility requirements, and creates household incentives to maintain the property. Failure to address the current financing needs of the housing market may result in a decapitalization of the banking sector, lost potential house value for many homeowners through foreclosure, and an extended episode of low growth for the U.S. economy. (JEL E44, E52, G01)

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Approximately 55 million homes have a mortgage, with an outstanding balance of $9.5 trillion (Goodman, 2011). In many areas of the country, housing prices have declined between 20 and 40 percent from peak values (Figure 1). And, as discussed in Garriga and Schlagenhauf (2010), declining house prices are highly correlated with home loan defaults (Figure 2). Mortgage default rates peaked at the end of 2009 and have not come down to normal values. Indeed, some analysts (e.g., Goodman, 2011) have estimated that, in the absence of policy changes, about 10 million borrowers are likely to default over the coming years--expanding the inventory of homes in an already soft selling market.

Currently, about 22 percent of homeowners are underwater: That is, the consolidated value of their mortgage debt is greater than the home value (Goodman, 2011). As discussed in a recent white paper from the Board of Governors of the Federal Reserve System (2012), underwater mortgages together with adverse economic conditions in the labor market--such as high unemployment (Figure 3)--and the inability to refinance or resell properties in an environment of declining prices appear to be the three main factors behind the high number of underperforming loans. A sizable group of homeowners may then be tempted to leave their properties, which in turn would further depress home prices. In this way, high unemployment rates, foreclosures, and declining home prices can have self-reinforcing effects.

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Although interest rates have dropped to historical lows during the ongoing economic recovery, housing prices continue to decline. If new rounds of conventional expansionary monetary policy (e.g., quantitative easing) may have only a minor impact on the housing market, what are the possible solutions to this problem? This paper advocates for a new program for loan modification called the 60/40 Plan (Diaz, 2008, patent pending).

MORTGAGES IN THE U.S. ECONOMY

In addition to the recent recession, the nation experienced a severe banking crisis. Monetary history (especially the recent Japanese experience) shows that banking crises may have long-lasting effects. Specifically, theoretical work in economics has revealed that markets fail to deal with problems of asymmetric information (adverse selection and moral hazard) in which the first-best outcome is usually not attainable. Some good assets may lose value because of unobserved characteristics or lack of due diligence. These assets are usually referred to as toxic assets and bad loans. And markets may be unable to overcome information problems in the trading and pricing of toxic assets: Economic agents may not truthfully reveal some asset characteristics or may not be willing to exert enough effort to protect the value of the asset. …

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