A White House nudge towards strategic default?

| January 25, 2012 | 0 Comments

By kyle flemming on Flickr

Ryan Lizza of The New Yorker Magazine has a lengthy piece out on the trials and tribulations of the Obama administration. It makes for very interesting reading and I’d be curious to hear what you make of it in this election year.

But what I’m most interested in is one of the source documents on which Lizza based his piece, and which he has made available to the general public here. It is, as he describes, a 57-page ur-text of the administration of the 44th president of the United States. It was delivered by Larry Summers, Obama’s former #1 economic adviser, on December 15, 2008 — after Lehman, after Bush’s TARP, after the victorious election, but before Obama’s inauguration. And with this economic context, its tone was as positive as you might expect. Which is to say, not very. Here’s how it begins:

In the absence of fiscal stimulus the economy is projected to lose 3 to 4 million jobs in 2009. Together with the jobs we have already lost and population growth, we will be 7 million jobs short of full employment. The unemployment rate is projected to rise above 9 percent and not projected to start falling until 2011.

In the memo Summers and other members of Obama’s early advisory team go on to discuss the various options they have for dealing with a crisis that they inherited. However I was most intrigued by the discussion of the various policy responses to the collapsing housing market. Here’s Larry writing to Barry:

Starting more than a year ago, you have expressed great concern with the dramatic rise of foreclosures and wanted a policy to do something about it. There were more than 2 million foreclosures in 2008, but with the deteriorating economy and further decline of the housing market, analysts expect there to be 5 million more non-GSE [non-Fannie Mae or Freddie Mac, etc.] foreclosures in the next 2 years.

We now know that there were actually about 3.3 million GSE and non-GSE foreclosures in 2009, and about 4 million GSE and non-GSE foreclosures in 2010, for a total of about 7.3 million foreclosures in these 2 years. So as bad as the Administration thought the housing market might be in 2008, it has arguably turned out to be worse, with foreclosures still quite high in 2011 (2.7 million), even despite the robosigning-induced moratorium.

In discussing tactics that might help this awful situation the memo makes clear that Obama’s economic team — primarily Summers, Austan Goolsbee, the former Chairman of Obama’s Council of Economic Advisers, and current Treasury Secretary Tim Geithner — focused on reducing monthly payments to “make mortgages affordable”.

We forecast that this effort will successfully prevent 1.5 million foreclosures.

We now know that it fell far, far short of even that modest goal.

While the Administration focused on making monthly payments more affordable, the memo did acknowledge alternative strategies. In particular, a strategy of encouraging principal write-downs, or principal mods, was rejected, for three reasons:

  1. It was thought that the historic driver of foreclosure was economic distress, and not borrowers “just walking away because the mortgage is underwater”.
  2. Principal mods would be extremely costly, given the large amount of negative equity present at the time (the memo estimates $1 trillion).
  3. “It is easier, legally, for servicers to justify modifying interest rates than writing down principal.”

These all strike me as logical arguments — at that time. However, as I wrote earlier this week, we now know that, per Joe Nocera and Laurie Goodman:

the only way to stop the [housing market] death spiral is through principal reduction. The reason is simple: “The data show that principal modifications work better” than other kinds of modifications, [Goodman] says. Interest rate reductions can lower monthly payments, but the home remains just as underwater as it was before the modification. And the extent to which a home is underwater is the single best indicator of whether the homeowner will default. The only way to change the imbalance between the size of the mortgage and the value of the home is to reduce principal.

So if the Obama Administration is really serious about getting this sector moving again, it’s going to have to look at this controversial strategy. And since this is No Drama Obama that we’re talking about, it’s hard to see him and his administration deciding for this tougher course of action on their own in an election year. What could possibly force him and his team to consider principal mods? The Summers memo has the answer (emphasis mine):

It is important to raise the prospect, however, that the current foreclosure crisis which is largely driven by economic distress and affordability, could morph into a new foreclosure crisis driven by walk-aways. If that happened, we would have to contemplate a policy geared explicitly toward negative equity.

A more cynical person might translate this as a dare: the Obama Administration will look at the policies that really work to avoid foreclosures only if it notices more and more homeowners starting to choose for strategic default. Will American homeowners drowning in underwater mortgages start to take them up on this? After all, it’s a policy that Mitt Romney also seems to endorse. Stay tuned.

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Category: Housing