Anthony Sanders: A voluntary private market solution

If the federal government really wants to stem the financial crisis, it must decisively address the huge — and still growing — number of delinquent and soon-to-be-delinquent mortgages, according to finance and real estate Professor Anthony Sanders. "The underlying core of the economy's problem is that the housing and mortgage market is still collapsing at record speeds," he said. Sanders proposed a voluntary private market solution in a December speech before the Dean's Council of 100, an advisory group at the W. P. Carey School of Business.

If the federal government really wants to stem the financial crisis, it must decisively address the huge — and still growing — number of delinquent and soon-to-be-delinquent mortgages, according to finance and real estate Professor Anthony Sanders of the W. P. Carey School of Business. "The underlying core of the economy's problem is that the housing and mortgage market is still collapsing at record speeds," he said in a December speech before the Dean's Council of 100, an advisory group at the W. P. Carey School of Business.

Both federal regulators and private lenders have tried tinkering with the mortgage market via proposals to reset the loans of struggling borrowers. The trouble is, their methods — freezing interest rates on adjustable-rate loans and extending mortgage lengths — have made little difference. Most borrowers who've received these sorts of loan modifications have ended up defaulting anyway, Sanders pointed out.

In fact, modified borrowers are re-defaulting at rates of between 50 and 60 percent. Instead, would-be mortgage doctors need to focus their efforts on the real cause of virus — disappearing equity. With house prices falling fast, more and more people are "upside down" on their mortgages, owing more than the market value of their homes. Any attempt to restructure these loans without adjusting the principal won't bring the market back into balance, Sanders said.

Throwing in the key

"What no one anticipated was that, as prices began falling, people would start throwing their keys back to the lenders," he explained. "They're walking away in record numbers. What's the cause of all of this? A lot of people in the market were speculators. There was fraud. And there was some poor underwriting." But plenty of folks are just making a rational, if risky, economic decision in response to plummeting prices, he said.

Laws in two of the states hit hardest by the crisis — Arizona and California — limit the ability of lenders to sue foreclosed borrowers to force them to pay the difference between the proceeds from the sale of their residence and their debt. "If you throw your keys to the lender, they can't touch you," Sanders explained. "They can ruin your credit — but there's no credit out there anyway. You can just walk away with no real consequences. Plus, in four years, your default disappears from your credit rating."

In a foreclosure, a lender often loses some of the money that it lent and faces hefty administrative hassles. In fact, loss severity on defaulted loans can run 50-60 percent of the loan balance. The lender ends up with a house that it can sell, but that's the last thing that lenders and investors want, Sanders said. (Many loans are converted into mortgage-backed securities and sold to investors like pension funds.)

Foreclosure is complicated and costly, and a seized house typically won't fetch top dollar because delinquent borrowers often stop tending their properties. Foreclosure, in other words, is a fool's game; everybody loses. The borrower loses his home and mars his credit, and the lender incurs costs to seize and sell the house.

A voluntary private market solution

Sanders argued that a better outcome for all would be reducing the principal amount of mortgages like these so that borrowers can remain in their homes and continue to pay off their loans, even if at a reduced rate. This isn't charity, he stressed. It's a way of saving money and stemming the problems. He wouldn't hazard a guess at the total price tag for cleaning up the mortgage mess but did say that restructuring loans would probably cost half as much as letting them all fall into foreclosure.

The federal government thus should encourage lenders and investors to write off part of the value of troubled mortgages, he said — that is, it should persuade them to reduce principal amounts to reflect slumping real estate values. Lenders and investors would then have to take losses on their books, but they wouldn't lose as much money as they would in foreclosures.

"Twenty percent write-downs trump 50 to 60 percent losses," he noted. Sanders called his proposal a "voluntary private market solution." To get lenders and investors to do this, the U.S. Congress, Treasury Department and Federal Reserve should coax and cajole, not threaten and demand, he said. Bullying could backfire badly, making lenders and investors, especially those from overseas, reluctant to make future loans in the United States.

In a November testimony before a congressional committee, Sanders suggested that principal adjustments could take a variety of forms. A lender might just cut the amount and be done. Or it could reduce it, but the government would then require the borrower to pay capital gains tax on the amount of the reduction when the house sold. That way, the government would recoup some of the cost of its wide-ranging effort to stabilize financial markets.

A lender might also enter into shared-appreciation mortgage with its borrower: it would grant a principal reduction in exchange for a share of the future appreciation when the house sold. Or a lender might allow a borrower to reduce the principal gradually, granting a small cut with each subsequent mortgage payment. That would encourage people to keep making timely payments.

Symptoms of an ailing market

Whatever method policymakers choose to encourage, they should act promptly because economic indicators still suggest an ailing market, Sanders said in his speech to the Dean's Council. As an example, he pointed to the growing spread between the interest rates charged on conforming and jumbo fixed-rate mortgages. Conforming loans hew to underwriting standards and size limitations set by Fannie Mae and Freddie Mac — the companies that purchase and securitize most U.S. mortgages.

Jumbos, in contrast, exceed Fannie and Freddie's size limits; they're common in regions with high home prices like New York City, San Francisco, Boston, Los Angeles and Phoenix. From the late '80s through the middle of last year, the spread between the two kinds of loans averaged about three-tenths of a percentage point, Sanders pointed out. Lately, it has approached two full percentage points — a more than fivefold increase.

"It's still going up," he said.

"That's a bad sign. Investors still aren't willing to buy this [jumbo] paper. This is particularly troubling for Maricopa County," which includes the Phoenix metro area. "Much of [the Phoenix] housing market happens to be jumbo mortgages. In Arizona, California, Nevada and Florida — the so-called Sand States — this is just getting worse."

The commercial mortgage market, considered one of the safer bets in real-estate lending, has deteriorated, too. Given the economy's travails — in early December, the National Bureau of Economic Research made its official determination of a recession — that makes sense. "Consumer spending is way down," Sanders said. "Retail sales are falling, and leases are in trouble." A commercial slowdown makes shoring up the housing market even tougher.

More people will lose their jobs and face problems repaying their mortgages. Even folks who remain employed may be squeezed if they took out adjustable-rate mortgages, as many borrowers did. The rates on these loans typically adjust upward after an initial low-rate period. Many borrowers haven't been able to afford their ARMs once they've ratcheted up, and more will face that fate in the next several years unless policymakers act.

Many subprime mortgages — that is, mortgages to people with poor credit histories or other financial warts — carried adjustable rates, as do many so-called "Alt-A" loans. Alt-A is a nickname for Alternative-A mortgages, which were designed to be riskier than conforming loans but not as risky as subprime ones. During the height of the real-estate bubble, some lenders offered Alt-A loans that didn't meet the usual requirements for documentation of income.

These came to be nicknamed "liar's loans" because some borrowers misrepresented their employment or finances. "Alt-A mortgages were originally low-documentation loans for high quality borrowers with excellent credit scores," Sanders said. "But lenders started making them to low credit-score borrowers with low down payments, so they became the new subprime. We stopped making subprime loans a couple of years ago, but we substituted Alt-A. They're now performing as badly as subprime."

Interest rates on many Alt-A loans are due to reset in the near future, and when they do, a large number of borrowers — many in Arizona, California, Nevada and Florida — will likely be unable to make their monthly payments. "This is like a rogue wave that's going to smash onto our shores," Sanders said. Those four states are also among the ones that saw the steepest declines in home values between mid-2007 and mid-2008. California and Florida have smacked especially hard, with drops of more than 20 percent in some regions.

"Among the worst places in the U.S. are the Inland Empire in California [the area east of Los Angeles] Monterrey and Carmel — who'd have ever thought they'd be going down 20 to 30 percent — and parts of the Northern Valley [which is west of the San Francisco Bay Area and includes cities like Stockton and Modesto]," Sanders said.

Other sapped locales have been Detroit, the urban corridor on the East Coast that stretches from Washington, D.C., to Boston and even New Hampshire. "New Hampshire — that's because of vacation homes," Sanders said. During the boom, many Bostonians and New Yorkers invested there. Much of the rest of the country saw price increases during that same period.

But those rises have typically come in regions with comparatively few people such as the Mountain West and the Great Plains. If there's a glimmer of good news amid all of this gloom, it's that home builders are responding rationally to the crisis — they're slowing construction.

"The inventory is declining, and that's great news for the housing market," Sanders said. "That's the best news we could hear. If you're working for a builder like Meritage Homes [based in Scottsdale], that's not the best news. But it's the best news for the housing market. We need to stop putting up supply until we clear the existing inventory."