Trading FHA Guarantees for Write Downs gets Congressional Support

The New York Times’ (3/13/08) “Bill to Propose Expanded U.S. Backing of Home Loans” reports that Rep. Barney Frank will introduce legislation to trade FHA guarantees for mortgage principal write downs. The government will not actually purchase any mortgages and participation will be voluntary. This is exactly what I said Bernanke was calling for in “Bernanke’s Harsh Warning”.

The Wall Street Journal’s (3/13/08) Ahead of the Tape column “Mind the Gap: Home-Price Downside” is focused on the imbalance between home prices and income. Goldman Sachs (GS) economists are predicting an additional 15% drop in home prices and Merrill Lynch (MER) is seeing a drop of 20% to 30% from here. It seems as though everyone outside the White House is seeing a permanent impairment in home prices.

I endorse the trading of principal write downs for guarantees. It legitimizes the new reality in real estate pricing. Until everyone agrees on a price level, both the real estate and mortgage markets will be stuck. Turning unrealized mortgage losses into realized losses will go a long way in creating liquidity in the mortgage security market, just as establishing a home price point “that we can believe in” will free up mortgage money.

Now for the troubling parts. The first issue is transparency. The voluntary nature of this plan is reminiscent of trying to ask a doctor or hospital for prices. There are no rules for healthcare transparency and likewise there are no rules for qualifying for this trade. Mortgage servicers have been purposely vague with the White House’s “Hope Now” program and there is no reason to believe that they will be more transparent with this program. Treasury Secretary Paulson has been unsuccessful in convincing the servicers to “streamline” anything. Paulson could not get any set of written rules in the hands of consumers.

The government also needs to guard against the mortgage investors only “volunteering” their worst mortgages. This penalizes both the government and borrowers that are struggling, but still making their payments. This program won’t work unless it is based on consumer choice rather than investor choice.

The second issue is appraisals. How can the government be assured that it is getting a fair appraisal for the property it will guarantee? It is in the mortgage investor’s best interest to get as high an appraisal as possible.

The third issue is second liens. I addressed this in detail in “Banks use Leverage to Force Home Equity Repayment”. Right now there are too many obstacles to implement any voluntary program. It is clear that Paulson is trying to be pragmatic, but that is a tough job in an idealistic “free market” White House.

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