Monday, July 18, 2005

Fact or Fiction?

A fictional, "what if" article set exactly two years in the future:
Real estate foreclosure crisis inspires desperate measures

Home Owners Loan Corp. II: A fable

Monday, July 18, 2005

Author's note: Home Owners Loan Corporation II was established by Congress on Aug. 7, 2007. The following is a transcript of the chairman's introductory comments at the first board meeting, held Sept. 12, 2007.

"Before we begin our deliberations on how to cope with the wave of foreclosures sweeping the country, a word about our predecessor institution.

The first Home Owners Loan Corporation (HOLC I) was established by Congress in 1933 to help families avoid having their homes foreclosed in the worst depression this country had ever seen. HOLC I refinanced loans of borrowers with mortgages in default, or held by distressed institutions.

HOLC I largely succeeded in its mission, refinancing about 20 percent of all qualifying home mortgages in the country, liquidating itself in 1951 at a slight profit to the government. This history no doubt was instrumental in the government reviving the model this year to deal with the current crisis in home finance.

This crisis is quite different from the one faced by HOLC I. Instead of a depression, we have had an eruption of inflation, comparable in magnitude to the one we experienced in the late 1970s and early '80s. As then, the inflation has caused a sharp spike in interest rates, but the consequences of the recent rate spike have been much worse. It punctured the housing bubble, with house-price declines especially large in areas where appreciation had been strongest. New construction in such areas has been cut in half, and construction of condominiums has ceased almost entirely.

Another major difference between this rate spike and the previous one is that this time we had many more mortgages with little or no equity before prices started to drop. This reflects both the widespread use of 80/20 first- and second-mortgage combinations in the financing of home purchases, and extensive cash-out refinancing for purposes other than building equity. In addition, a substantial proportion of outstanding mortgages are adjustable-rate (ARMs), many with the option to pay interest only, and in the case of option ARMs, even less.

It is estimated that 9 million mortgages are now underwater – the loan balance exceeds the value of the property. A large proportion of those are interest-only and option ARMs, on which the interest rate and mortgage payment are rising as we speak.

As per its instructions from Congress, HOLC II will follow its predecessor in refinancing mortgages in some stage of default but not yet in foreclosure. However, where Congress set eligibility requirements for HOLC I, it has delegated this responsibility to the board of HOLC II. The only guidance we have is that eligible borrowers should be those in distress 'through no fault of their own,' and that we cover our costs over the life of the agency, as HOLC I did.

Our staff recommendations for defining eligibility are considered to be consistent with the Congressional guidelines.

1. We will only refinance mortgages on which the balance does not exceed our estimate of "long-run sustainable value" (LRSV). The LRSV will be above current market prices but below the prices reached before the crash. HOLC I followed a very similar rule.

2. Only mortgages secured by the borrower's primary residence will be considered. Mortgages on second homes and rental properties are not eligible.

3. Mortgages larger than $1 million will not be eligible.

Unfortunately, less than one in 10 of the mortgages now underwater meet these conditions. A large proportion are in what had been the hottest markets, where current prices are well below LRSVs, and balances had not been paid down because of the popularity of interest-only and option ARMs. Many of the underwater mortgages are on second homes and rental units, which had been purchased on speculation. And a surprising number is larger than $1 million, with a concentration in California.

Unlike HOLC I, HOLC II has no authority to refinance loans held by distressed institutions if those loans are not otherwise eligible. The earlier Congress was concerned about bank failures, which could cause loss to depositors – deposit insurance did not arise until several years later. The Congress establishing HOLC II had no such concerns. It took the position that lenders who loaded up on inherently risky ARMs in go-go markets should bear the full consequences of their folly."

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