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February 24, 2009
Foreclosure mitigation: What we think we know
One of the most important challenges facing policymakers today is reducing the rate of mortgage foreclosures. It is a goal many think is at the heart of a sustained recovery in the U.S. economy. But as past attempts to reduce financial stress on homeowners have shown, the task is not easy. One of the complicating factors in formulating successful foreclosure mitigation policy is getting at the heart of the relationship between negative equity (the situation where the remaining mortgage balance is greater than the value of the house) and actual foreclosure.
Economic theory poses one categorical prediction about this relationship, which is that negative equity is a necessary condition for default. In other words, if a borrower is not in a position of negative equity, then he or she should never default. This conclusion follows simply from the fact that positive equity implies a borrower can sell the house, pay off the mortgage, and keep the difference—a better outcome under any circumstance compared with stopping payment on the mortgage and leaving the home.
What economic theory does not say is that if a borrower has negative equity, he or she should always default. The reason for this is that the owner could always default in the future, and thus there is value in waiting to see if house prices recover. Now, this value to waiting differs across borrowers and is sensitive to both the depth of negative equity and a borrower's financial situation. Why does a borrower's financial health matter? Well, the cost of waiting includes the monthly mortgage payment the borrower must continue to make. Borrowers who have plenty of wealth and a steady stream of income will be more willing to continue making payments than borrowers who are in financial distress, perhaps related to an unemployment spell or some other adverse financial shock.
So why does all of this matter in terms of thinking about a successful foreclosure mitigation program? Well, the appropriate policy prescription depends on the particular reason a borrower is currently considering default. I think it is useful to break things down in terms of three (not necessarily mutually exclusive) groups of mortgage borrowers:
- those in unaffordable mortgages from the very beginning, who were implicitly relying on increasing house prices to refinance or sell for a profit;
- those who have been hit by an adverse, but temporary, income/financial shock; and
- those who purchased the house for strictly investment purposes and now see little or no hope of making a profit.
Borrowers may find themselves with unaffordable mortgages for many reasons. One might be an unscrupulous mortgage broker, who steered the borrower into an unaffordable subprime loan in order to generate high origination fees. Another, related situation would be an unaffordable interest rate reset on a subprime adjustable-rate mortgage. Finally, some mortgages may be permanently unaffordable because a buyer misrepresented income or assets during the origination process, a situation made easier by the growth of low documentation mortgages.
A large part of the administration's new housing plan—summarized succinctly by the New York Times, with lots of commentary (negative and positive) rounded up at Economist's View—is reasonably interpreted as being directed squarely at borrowers in the unaffordable-mortgage group. If policy is to be aimed at helping this group, the prescription is to offer the borrower a permanent reduction in monthly payments, whether it comes from lowering the interest rate, lengthening the maturity, and/or reducing the outstanding principal balance on the loan. The measuring stick often used in such plans is the debt-to-income ratio (DTI), which is the borrower's monthly mortgage and/or total required debt payments relative to his or her gross monthly income. While the administration's plan would succeed in lowering DTIs, the policy is temporary in nature (five years), and it is unclear what would happen to these borrowers after the plan runs its course—especially if negative equity is still an issue.
Many borrowers might have been able to afford their mortgages while employed but can no longer do so after they have lost their jobs. When housing prices are rising and homeowners enjoy positive equity, then distressed borrowers are able to sell their homes to pay off their mortgages. Alternatively, such borrowers can undertake cash-out refinances to gain some much-needed liquidity. Note that problems can occur for people in this situation even when positive future equity is a realistic hope. If the borrower is unemployed and liquidity constrained, the cost of waiting to default is very high and potential future price gains are of little value. Default in this case is much more likely, even though future prospects might be reasonably good. In this case, foreclosure-prevention policy could simply be used to eliminate the financial friction. In this case a lender would offer "forbearance," in which the borrower pays significantly lower payments for some period, with the arrears made up (with interest) later on. In this light, it is notable that the administration's key payment reduction plan has a five-year window.
However, one important concern regarding the plan is that servicers/investors don't have enough incentives to substantially decrease current DTI ratios. For example, if a household has a DTI of 60 or 70 because of a job loss, the servicer is responsible for modifying the loan to get DTI down to 38 and then still has to kick in a 50 percent match to further reduce it to 31. The costs borne by the servicer/investor are much larger than those borne by the government, which may not be such a bad thing in principal but in practice may result in low participation rates.
Note also that while permanent relief is the prescribed course for borrowers in the unaffordable-mortgage group, temporary relief is indicated for those in the temporary economic distress group. This highlights the difficulties in constructing policies when the underlying sources of stress differ by individual. The existence of a class of borrowers that purchased and financed residential real estate primarily for investment purposes further complicates matters. People in this group are in much different circumstances than those in the other groups and will default much more ruthlessly. A so-called "ruthless defaulter" has given up hope of positive future equity and hence there are no potential price gains to value. Under the theory of ruthless default, one effective policy intervention is to lower the outstanding balance of the mortgage so that positive equity—or even the hope of positive equity in the near future—is restored. Alternatively, the lender could forestall default at least temporarily by cutting the monthly payment below the cost of renting an otherwise observable house.
Aimed as it is at owner-occupied housing, the administration's plan does not offer direct assistance to those in the investment class. That may not be too surprising, as it is hard to generate much political sympathy for a group carrying a label like "ruthless defaulter." In addition, the perverse incentives of government assistance that usually go by the name of moral hazard are arguably more severe for individuals who purchase properties for investment purposes. However, abandoned properties do add to the stock of unsold homes, independent of who owned them or why they owned them. This does not necessarily argue for policy relief for investment buyers, but it is potential issue that bears watching.
Finally, there may be commentators with the view that loan modifications are a failing proposition as a few studies have shown extremely high default rates on modifications performed in early 2008 (for example, see OCC and OTS Mortgage Metrics Report, Third Quarter 2008). But, according to the table below (based on my calculations), the problem seems to be that the wrong type of modification was being performed. Approximately two-thirds of the modifications performed by servicers in the first two quarters of 2008 had the effect of increasing the principal balance of the mortgage and, as a result, also increased the borrower's monthly mortgage payment. In light of the above discussion, we should not be surprised by high re-default rates on these loans. On the other hand, there is reason to believe that successful implementation of payment reduction programs may indeed help to stem the pace of foreclosures.
By Kristopher Gerardi, research economist and assistant policy adviser at the Atlanta Fed
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February 18, 2009
The American Recovery and Reinvestment Act in pictures
A year-by-year look at where the money goes:
Note: The dollar amounts listed below are denominated in millions of dollars.
Which adds up to:
Finally, the relative size of each year's spending:
There you have it.
By David Altig, senior vice president and research director, and Courtney Nosal, economic research analyst, at the Atlanta Fed
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February 13, 2009
How bad is the employment picture, really?
Could it be worse than I thought? We quite likely have not hit bottom in the labor market yet, and the percent loss in nonfarm payroll employment since the beginning of the current recession is already worse than all of the previous seven recessions save the 1981–82 contraction:
I thought that was not so great, until I took a look at Spencer England's chart posted by Barry Ritholtz at the Big Picture. (The graph had shown up earlier at Angry Bear and was noted in turn by William Polley.)
Like my graph above, Spencer England's provides a cross-recession look at employment losses, but based on data from a survey of households (as opposed to payroll data collected from business establishments). Here's my version of that chart:
From that look, the labor market in this recession is off-the-charts bad.
There are several reasons the payroll and household employment statistics might differ, and I was puzzling over them when Menbere Shiferaw, one of the many ace analysts here at the Atlanta Fed, came to my assistance. Deep in the details of the latest Bureau of Labor Statistics employment report is this:
"Effective with data for January 2009, updated population estimates have been used in the household survey… Each year, the Census Bureau updates the estimates to reflect new information and assumptions about the growth of the population during the decade. The change in population reflected in the new estimates results primarily from adjustments for net international migration, updated vital statistics information, and some methodological changes in the estimation process…
"Data users are cautioned that these annual population adjustments affect the comparability of household data series over time. Estimates of large levels such as total labor force and employment are impacted most."
So it may not be such a good idea to use the household employment data to benchmark the job picture with past recessions. And I think I'll stick with the payroll series for historical reference. Nonetheless, I think we can readily agree that both series are giving us a similar message about the labor market in the here and now, and that message isn't a good one.
By David Altig, senior vice president and research director at the Atlanta Fed
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February 06, 2009
Contraction, not tightening
Over at Financial Crisis and Recession, Susan Woodward and Robert Hall start a recent post, titled "The Fed contracts," with this:
"The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments…
"But... the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holding of higher-yielding investments…. So far, no explanation for the Fed's announcements of moving in an expansionary direction while actually contracting."
First, it is probably appropriate to point out that the use of the term "quantitative easing" is a bit out of synch with the policy approach embraced by "the Fed." This is from Chairman Bernanke's January 13 Stamp Lecture at the London School of Economics:
"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach—which could be described as 'credit easing'—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental… In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."
At Economist's View, Tim Duy zeroed right in on the point:
"Woodward and Hall are confused because they do not recognize that the Fed has not initiated a policy of quantitative easing…because the Fed sees their actions as credit market related, they would have no problem with the balance sheet contracting if credit market conditions dictate."
What Woodward and Hall describe is credit easing in the Bernanke lexicon, as "expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments" is a description of changes in the composition of Federal Reserve assets. But the intent they assume is that of quantitative easing—which in the end is all about expanding the size of the balance sheet (on the liability size specifically).
In our opinion—and we rush here to add that is only our opinion—the key to unwinding the Woodward-Hall "puzzle" is in the last sentence of the Bernanke quotation above: "the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses."
It is instructive to examine the source of the recent reduction in the Fed's balance sheet.
Though several categories of Fed assets have declined in recent weeks, the really large changes have been in currency swaps and the Commercial Paper Funding Facility or CPFF. In simple terms, currency swaps are the provision of dollars to foreign central banks to help satisfy dollar-based liquidity needs in foreign financial markets, the CPFF is a Federal Reserve funding facility to assist in the functioning of domestic commercial paper markets.
As the Chairman suggested in his Stamp Lecture:
"…when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities."
At least in U.S. dollar interbank lending markets, liquidity pressures have abated, as LIBOR rates have fallen substantially since last fall and have held relatively steady in recent weeks, and term financing premia have similarly eased.
Commercial paper yield spreads have also narrowed considerably for both asset-backed and financial paper since the introduction of the CPFF last fall:
Interestingly, a large amount of maturing CPFF paper was not reissued into the CPFF or the market in late January. This decline could be a result of some borrowers shifting to other, cheaper sources of credit. From CNNMoney:
"The Fed's commercial paper funding facility was a popular alternative for cash-strapped corporations at the height of the credit crunch, but demand for funding through the program has waned. Another government sponsored program, the FDIC's Temporary Liquidity Guarantee Program backs financial institution debt issued up to 10 years, a more attractive alternative for many companies."
There is one additional wrinkle. Agency mortgage-backed securities—which the FOMC has authorized the purchase of, up to $500 billion—show up on the balance sheet at the time the trades settle. As of February 4, the Fed's balance sheet has $7.4 billion in Agency MBS. However, if you sum the purchases that the NY Fed posts on their Web site, the total is closer to $92 billion so far. Thus, roughly $85 billion in MBS the Fed has purchased have yet to show up on the balance sheet because the trades haven't settled. (Hat tip to our colleague Mike Hammill for bringing this to our attention.)
The central bank's balance sheet is in fact contracting. Maybe. But is it policy tightening? Doubtful.
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February 05, 2009
There is no accounting for priorities
Just in case you are desperately seeking some refuge from the pervasive blogland commentary on the fiscal stimulus proposal winding through the Senate (which already made its way through the House of Representatives), be forewarned: You won't find it here, but you will find an update to the old adage, There's no accounting for taste (de gustibus non est disputandum), which is to say that when it comes to the fiscal stimulus package, there's no accounting for priorities.
The Senate bill is not yet a done deal, of course, but a couple of clear differences between it and the House bill have emerged. According to the Congressional Budget Office—or CBO, from whom all figures in this post spring—the Senate bill is slightly bigger ($884.5 billion versus $819.5 billion) and would implement the stimulus at a faster pace. The current Senate bill would introduce about 79 percent of the expenditures and tax cuts in 2009 and 2010. The corresponding figure in the plan that came out of the House is 64 percent.
Perhaps more interesting—and maybe more confusing—are the priorities reflected in the separate bills:
The share of the stimulus devoted to discretionary spending—the place where, for example, infrastructure and education spending reside—is pretty similar in both stimulus plans (about 28 percent in the House version, about 26 percent in the Senate version). What is clearly different is the much greater reliance on tax cuts in the Senate bill, compared with the House bill's emphasis on "direct spending."
In a sense, this distinction is as much an issue of labeling as anything. The majority of the items in this category of direct spending are "provisions that would increase direct spending for unemployment insurance, health care, fiscal relief for states through the Medicaid program, and other programs," according to the CBO. In the language of economists and national income accountants these are "transfer payments," or funds that are transferred to individuals. Formally, they are subsidies for certain types of economic behavior—job seeking and purchasing health care, for example—and hence are really just a negative tax.
There is a certain arbitrariness to the distinction between increases in transfer payments and reductions in tax payments. This arbitrariness is illustrated by a change the CBO made between its initial assessment of the draft House bill and its (largely unchanged) summary of the bill that passed:
"The Congressional Budget Office, in consultation with JCT [Joint Committee on Taxation], has concluded that the subsidy for health insurance assistance for the unemployed should be treated as an increase in outlays rather than a decrease in revenues. Although this treatment is different from that in the table provided in our estimate for H.R. 1 as introduced on January 26, the overall effect on the budget remains the same for each year. JCT has also adjusted its estimates of the mix of revenue losses and outlay increases associated with certain refundable tax credits; that change also has no effect on the budget totals for each year."
Still, if you are likely to be on the receiving end of one of these programs, the distinction is probably not so arbitrary. From this end-user perspective, there is an important economic distinction between approaches taken in the competing plans. So then, which approach to "tax cuts" is better? At this point, I will send you to the aforementioned pervasive blogland commentary. You will find no shortage of opinions.
By David Altig, senior vice president and research director at the Atlanta Fed
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