Does the mortgage crisis demand a government bailout?

A year ago, most experts thought not. Sad as the situation was for some homeowners, many experts felt the problem would be confined to those who had gambled on risky loans with eyes open — borrowers who chose adjustable-rate loans sure to require higher payments later, lenders who invented exotic loans likely to suffer high default rates, hedge funds and other big investors who had lusted after high-yielding mortgage-backed securities.

But things have changed. The mortgage crisis is behind a nationwide drop in home values and a crisis in confidence that is impeding all types of lending. People who did not choose to take risks are suffering, and more and more experts now say some sort of government response is necessary to avert a deep and prolonged recession.

“Now it’s our problem, and it isn’t getting any better. As we speak, it is getting worse,” says Wharton finance and real estate professor Susan M. Wachter, who warned a year ago that the subprime mess could push the economy into recession. She favors new legislation or regulation to give trusts that control mortgage-backed securities incentives to work with homeowners.

Others warn of “moral hazard” — creating a safety net that encourages risky behavior. And some worry that bailing out borrowers, lenders or investors who made mistakes will be too expensive and unfair to those who played it safe. “We’re going to have to work out these loans,” says Wharton real estate professor Joseph Gyourko. “But I think it’s not a wise idea to bail out people who made risky, unwise decisions…. I think the banking sector, which made these loans, needs to live with them.”

Accusations of Foul Play

Nationwide, about six million of the 45.4 million mortgages are categorized as subprime. Typically, those carry adjustable rates that start out low but reset later to levels higher than charged by ordinary “prime” mortgages. Subprime loans were touted as a way to offer mortgages to people who could not get ordinary loans because of low incomes or poor credit histories.

But many other borrowers were drawn to subprime loans by low introductory “teaser” rates, which allowed them to get smaller starting payments or to qualify for bigger loans. Some subprime loans required no proof of income, making it easy for borrowers to become over-extended.

As interest rates rose in 2007, resets boosted the monthly payments for many subprime borrowers. At the end of the third quarter of 2007, nearly 7% of those loans were in foreclosure, compared to 0.8% for ordinary “prime” loans, the Mortgage Bankers Association says. Nearly 17% of subprime borrowers were behind in payments, compared to 3.3% for prime loans. Some surveys suggest two million homeowners could face foreclosure this year, up from 1.5 million in 2007 and one million the year before.

Rising foreclosure rates, and fears they will rise further, have pricked the housing bubble. Nationally, home values fell 8.9% in 2007, the largest drop in the 20-year history of the S&P/Case-Shiller Home Price Indices. Many experts say prices could fall another 10% this year. The result is that government agencies, politicians, consumers groups and think tanks are stumbling over one another to propose remedies.

The problem: Some approaches risk billions in taxpayers’ money, perhaps hundreds of billions, and any intervention in the marketplace is likely to favor one group over another, leading to cries of “foul.”

At the end of February, Republicans blocked a proposal by Democrats to allow bankruptcy judges to reduce homeowners’ mortgage debt, arguing that would be unfair to lenders. The Bush administration has rejected — as a costly bailout for lenders — a suggestion that the government buy up mortgage debts at a discount, cutting borrowers’ payments and saving lenders and investors from further losses. It has instead urged lenders to freeze interest rates for some borrowers facing big increases in resets.

In a March 4 speech, Federal Reserve chairman Ben Bernanke urged lenders to voluntarily reduce the remaining mortgage debt for borrowers whose homes are worth less than they owe. While this would reduce the lenders’ mortgage income, Bernanke argued it would avert foreclosures that would cost the lenders even more.

The fairness dilemma is outlined by Wharton real estate professor Todd Sinai in a February 2008 paper titled, “The Inequity of Subprime Mortage Relief Programs,” published by the FreedomWorks Foundation, a non-profit that advocates “lower taxes, less government and more economic freedom.”

The American Securitization Forum, for example, wants to freeze adjustable-rate subprime mortgages at their teaser rates for five years, saving borrowers from the higher payments they otherwise would face when their rates reset one, two or three years after the loans are issued. But this will leave the subprime borrowers who chose risky loans better off than the borrowers who more wisely chose conventional fixed-rate loans, Sinai writes. “The benefits of borrower relief programs will be highly concentrated geographically, but the costs will not.”

All taxpayers would share the burden of a government bailout, but the chief benefits would go to homeowners in four states. Sinai calculates that California has 25.7% of the country’s subprime debt, Florida 10.2%, New York 7% and Texas 4.1%. This is caused by high home prices and, in California and Florida, an especially prevalent use of subprime loans.

The recently passed economic stimulus package included a provision to raise the limit on the size of mortgages that can be backed by the government-sponsored companies Fannie Mae and Freddie Mac, from $417,000 to $729,750. This is meant to make it easier for troubled homeowners to refinance to fixed-rate loans.

But Sinai notes that this measure mainly helps well-to-do borrowers, since only they can afford mortgages larger than $417,000. Many of these borrowers, he points out, willingly took on high-risk loans. Among loans larger than $417,000 issued during the first half of 2007, almost two-thirds of the dollar amount involved adjustable-rate loans that allowed borrowers to pay only interest, or to pay less interest than the loan charged, with the shortfall being added to principal. These are high-risk loans.

“The proposals that were on the table when I wrote this [paper] in December and January provide a stunning amount of relief to borrowers who elected to take very high-risk mortgages,” Sinai says. He was especially surprised to find the use of subprime loans by well-heeled borrowers. In 2006, high-cost loans — those charging at least three percentage points above the yield on Treasury bonds — made up 25% of all loans issued to people earning between the median income and 1.5 times the median income. The figure was 20% for those making more than 1.5 times the median income.

The best solution to the foreclosure problem, suggests Sinai, would be to offer low-interest, fixed rate loans to everyone. That would give troubled homeowners a chance to refinance without favoring them over other borrowers.

A Housing-driven Recession

According to Wachter, the standard response to collapsing bubbles — letting the marketplace sort it out — is not likely to work in today’s housing crisis, which comes as home prices fall after years of extraordinary gains driven by cheap money. “We are going into a recession, or are in a recession — a housing-driven recession, which is the first in our history,” she says. “The self-correction mechanisms are simply not there.”

In a classic market, such as manufacturing, excess supply causes prices to drop below production costs, and production then dries up. As inventories shrink, demand drives prices back up and production resumes: The market finds equilibrium. Indeed, this process is beginning in the home-construction industry as builders cut back, Wachter says. “But that’s not the full picture. The full picture has got to include another source of supply, and that supply is coming through foreclosures.”

She envisions a vicious cycle. Homeowners who are unable to make payments fall into foreclosure and their homes are put up for sale. That boost in supply will drive other homes’ values down, leaving more homeowners with properties worth less than they owe on their mortgages. Many homeowners who otherwise would struggle to continue making payments despite financial reversals will simply stop making payments under these conditions, feeding more foreclosures. “That process is not self-correcting,” Wachter says. “In fact, quite the contrary. It is reinforcing.”

She believes the solution lies in new legislation or regulation to give market participants stronger incentives to work with troubled homeowners. The target should be trusts, mostly controlled by big banks, which oversee the baskets of securities that have been bundled together and sold to investors.

Gyourko agrees that the market should not be left to right itself, although he is wary of big bailout schemes. The crisis has become so large it threatens the entire economy, not just people and institutions that chose to take ill-conceived risks, he says. And, he adds, the market is not in a position to handle the problem of foreclosures efficiently because the typical loan is no longer held by a local bank which has a handle on the borrower’s situation and an incentive to find a solution other than foreclosure. Instead, loans have been bundled into securities sold to investors all over the world.

This creates difficulties not faced in the savings and loan crisis of the 1980s. The S&Ls kept possession of the bad loans, making it relatively easy for the government’s Resolution Trust Corporation to take them over.

‘Negative Equity Certificates’

As a result of the more recent shift to securitization, foreclosure decisions are hampered by communication issues and uncertainty about rules and regulations. Foreclosure may be so inefficient that little money may be recovered, Gyourko says. “If the money I am willing to pay on my debt is greater than the bank can get for my house in foreclosure, it is inefficient foreclosure,” Gyourko says, adding that working out a compromise between lender and borrower would then be preferable.

Gyourko favors a suggestion by the federal Office of Thrift Supervision, which regulates savings and loan institutions, which would encourage creditors to write down homeowners’ debts, reducing monthly mortgage payments. In return, creditors would receive “negative equity certificates” that would give them a share of any gains the homeowner made on a subsequent sale.

If a homeowner owed $100,000 on a property now worth only $80,000, the monthly payment would be reduced to that of an $80,000 loan, Gyourko says. But if the property later sold for more — $120,000, for example — the creditor would receive $20,000 from the proceeds. A similar process is often used in corporate bankruptcies, where debt is replaced with equity.

This way the taxpayer would not be on the hook for the creditor’s losses, but creditors would have an incentive to work with borrowers, Gyourko says. “My view of the proper role of government is not that you need a new government housing agency, as in the Great Depression. I think the government’s role is to help us through the regulatory maze.”

Some experts think modest measures should be tried before the government resorts to sweeping programs. Andrey Pavlov, a visiting finance professor at Wharton, argues that the chief problem is fear in the credit markets, which makes institutional investors unwilling to buy and sell exotic securities based on mortgages and other types of debt. “Wall Street isn’t buying right now…. It’s really hurting the economy,” he says.

The Federal Reserve or some other federal agency could prime the pump by organizing a limited securities sale, perhaps promising to step in as a buyer if no others appear, Pavlov suggests. This would induce other traders to assess the securities’ values. Once this process of price discovery was started, the market might reignite, he says.

Conditions may eventually get bad enough to justify a government bailout, putting the taxpayer on the hook to some degree, adds Ken Thomas, a lecturer in finance at Wharton. But for now he favors a “bottom-up” approach that would press lenders to compromise with troubled borrowers.

Current efforts of this type, such as the voluntary Hope Now program sponsored by the Department of Housing and Urban Development, are inadequate because they focus on homeowners already in deep trouble — typically as much as 90 days behind in payments, Thomas notes. Instead, he says, lenders should write to all borrowers to encourage them to start talking about a solution as soon as they suspect they may have a problem. “They’ve got to get to them before their problem starts. That’s not happening now. We’re just helping the people who already have one foot in the grave.”