January 14, 2009 (Housing Market Monitor)

Plans to “Help” Homeowners Send Checks to Banks

January 14, 2009

By Dean Baker

Paying above market prices for mortgages subsidizes banks, not homeowners. 

As Congress debates the release of the second half of the TARP funds, there have been demands that much of this money be used to help homeowners. It is important to recognize that most of the proposals to help homeowners would involve sending large checks to banks. The homeowners who ostensibly benefit in these plans would typically be left in a home with little or no equity.

The basic design of these proposals involves having the government guarantee a new mortgage that is set at a price close to the current market value. (In some cases, the mortgage may be set a level somewhat below the current market value in order to give the homeowner some equity.) The guarantee itself may require some fee from the homeowner (as in the plan passed by Congress last summer), or it may be explicitly designed to be a subsidy from the government through TARP money. Of course, if the appraisals fail to include the impact of deflating house prices in bubble areas, then the guarantees will involve a subsidy, even if unintentionally.

However, the major subsidy is in the form of the payment for the original mortgage. If the situation were left to the market, the lender holding the original mortgage would almost certainly collect far less than the current appraised value of the home. If the lender moved to foreclose, they may be able to sell the home at this price, but they would lose between 10-20 percent of this price in costs related to the foreclosure.

By contrast, the plans currently being debated would pay banks substantially more than the current market value of homes in exchange for selling the initial mortgage. For example, if a homeowner has a mortgage on a home for $300,000 and the current market value is $200,000 then, under some plans, the lender would walk away with $250,000 from the government for selling off its first mortgage (half the price difference). This would amount to a subsidy to the bank on the order of $70,000 to $90,000 (assuming a range of 10 percent to 20 percent for foreclosure costs).

This subsidy is likely to be considerably more valuable to the banks than the other money received through the TARP, which takes the form of a loan. In that case, the subsidy is the difference between the market rate of interest and the interest rate that the Treasury charges on the loans. For example, if the Treasury lends money a bank $1 billion at a 5 percent rate and the market rate at which this bank would have to pay to borrow is 10 percent, then the subsidy is 5 percent or $50 million a year.

By contrast, if the government buys mortgages from this bank for $1 billion, which only have a market value of $700 million then the government has effectively handed $300 million to the bank. In other words, the banks are likely to get much larger subsidies from the government through plans ostensibly designed to help homeowners than they would through the other components of the TARP.

There are mechanisms for helping homeowners that are less generous to banks. For example, Congress could temporarily change the rules on foreclosure to give homeowners facing foreclosure the right to remain in their house as renters for a substantial period of time, paying the market rent. Congress could also change the bankruptcy law to allow judges to alter the terms of a mortgage contract in bankruptcy.
Both of these measures would substantially increase the bargaining power of homeowners seeking to negotiate new terms on a mortgage that they cannot pay. Neither requires taxpayer dollars or any new bureaucracy.

If it is the intent of Congress to help homeowners with the TARP, then it could add a clause that would allow the subsidy that they would otherwise pay to banks, instead to go directly to homeowners. This means that if the TARP was prepared to pay $30,000 above the market value for a mortgage, it could offer the homeowner the $30,000 instead and then let her decide what to do with the money.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.