The Role of Government and the Foreclosure Crisis

September 20, 2010

Dean Baker
Truthout, September 20, 2010

See article on original website

As we all know, there are two competing views on the proper role of government. On the one hand, we have those who believe that it is the government’s responsibility to redistribute as much income as possible upward to the richest people in the country. On the other hand, there are those who believe that government should promote a strong economy that serves the vast majority of the population.

Adherents of the former group in both political parties have been firmly in control of government in recent decades. This comes out very clearly in the treatment of the foreclosure crisis.

The basic story of the foreclosure crisis is that banks made trillions of dollars on bad mortgage loans that were used to buy or refinance houses at bubble-inflated prices. With the collapse of the housing bubble, more than a fifth of all mortgages are underwater. As a result, many homeowners are struggling to pay mortgages on houses in which they have no equity and have no real prospect of ever getting equity.

This is where the two competing views of government come in. If the market is allowed to run its course, millions of homeowners will default on mortgages leaving banks and investors with large losses.

The largest banks are especially vulnerable in this area since the four big banks own hundreds of billions of dollars in second mortgages. In the event of default these second mortgages will be mostly worthless, since the holder of a second mortgage gets nothing from the sale of a foreclosed home until the first mortgage is paid in full. If a home is already underwater, then legal costs and sales fees are likely to eat up a large enough share of the sale price to prevent the first mortgage from being paid off, leaving nothing for the holder of the second mortgage.

Those who believe that is the role of government to redistribute income upward and help the banks want the government to get people to keep paying on underwater mortgages as long as possible. While this may make little sense for these homeowners, since they will never accumulate equity and are likely paying more in ownership costs than they would pay to rent a similar house, it does help the banks’ bottom line. Each additional month that underwater homeowners stay in their homes paying the mortgage the banks are getting money they would not otherwise receive.

This explains the value of a program like the Home Affordability Modification Program (HAMP). Only a small fraction of the people who enter this program will end up with a permanent modification that will actually allow them to accumulate equity. However, the whole time that they work with the program, they keep sending a mortgage check to the bank  — and the government kicks in some taxpayer dollars as well. This is a real win-win from the standpoint of the banks as they get more checks from the homeowner than would otherwise be the case, plus the subsidy from the government for stringing homeowners along.

Those who have the competing view – that the role of government is to foster a strong economy and help the bulk of the population – instead support measures that would directly help homeowners. For example, bankruptcy cramdown would make it easier for homeowners to declare bankruptcy and hold onto their homes.

Even better, the government could pass “right to rent” legislation as proposed by Representatives Raul Grijalva and Marcy Kaptur. This bill (HR 5028) would allow homeowners to stay in their home as renters for up to five years following a foreclosure. During this period, they would pay the market rent for their house as determined by an independent appraisal.

This bill would provide real housing security to homeowners facing foreclosure. It would also prevent a glut of vacant foreclosed homes from driving down property values and destroying neighborhoods. In addition, it would give banks more incentive to negotiate meaningful modifications with homeowners, since it would make the foreclosure route much less attractive. The Grijalva-Kaptur bill also would require no new government bureaucracy and would cost the taxpayers nothing.

But, right to rent legislation would require a different view of government – one that believes that the government is responsible for helping ordinary people. As we know, those who believe in redistributing money to the rich control the government. So, look for more plans to “help homeowners” by giving money to banks.

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