When Government Gives Defaulters a Pass
The problem was predictable. The government rolled out a massive mortgage rescue program, and some homeowners who could afford to pay their mortgages based on the terms that government was offering decided instead to walk away from the loans, sometimes after stringing the government along and living rent free for a time. Frustrated, government overseers of the bailout program controversially decided to start suing some of those who default to stop the problem from getting worse.
This is an apt description of Washington's current Home Affordable Modification Program, or HAMP. With Fannie Mae reporting growing numbers of homeowners simply walking away from homes, the government is now seeking sanctions against so-called strategic defaulters, those who can afford a mortgage but bail anyway.
But what's happening with HAMP is just a replay of the experiences of a former federal mortgage bailout program, the 1930's Home Owners Loan Corp., which might be called the mother of all mortgage bailouts. Back then, with government in full control of the machinery of the bailout through a giant federal bureaucracy, the feds learned that giving mortgage holders a little leeway inevitably prompts some of them to take advantage at the taxpayer's expense. The pattern emerging in HAMP, in other words, is not unique and shouldn't be surprising.
Still, Fannie Mae's new policy of pursuing in court strategic defaulters is predictably controversial, and some Congressional Democrats are looking to end it. Rep. John Conyors, chair of the House Judiciary Committee, and Ohio Rep. Marcy Kaptur are seeking additional co-signers of a letter they are circulating calling Fannie Mae's new policy "opaque, overbroad and punitive." They want Treasury Secretary Tim Geithner and the Federal Housing Finance Agency, which regulates Fannie Mae, to stop the lawsuits, which they claim are an inappropriate use of taxpayer dollars at a time of record deficits.
The new Fannie Mae policy, which also includes banning mortgage holders who walk away from loans from obtaining future government-backed mortgages, comes at a time when strategic defaults remain high. In June, a report by Experian, a consumer credit agency, suggested about 19 percent of all defaults in mid-2009, the most recent data period available.
One reason these strategic defaults are still common is the growing practice of ‘buy and bail' among well-off homeowners whose mortgages are greater than the value of their homes. According to real estate professionals, some of these homeowners are now obtaining a mortgage to buy a new home that's cheaply priced thanks to the soft market, and then walking away from their current home and mortgage. By borrowing first these homeowners avoid the kind of sanctions against new borrowing that Fannie Mae is putting in place for strategic defaulters, but they still benefit from the depressed market with a new, more inexpensive home that's a better investment for them.
The issue of mortgage walk-aways remains a fault line in the debate on the mortgage meltdown. Even while some Dems question the Fannie Mae policy, last month Republicans inserted an amendment into the House's version of a Federal Housing Administration reform bill that banned lenders from making government-backed loans to borrowers who previously defaulted on a mortgage they could afford. Republicans and others who are critical of the growing practice of strategic default say that without such sanctions the problem will put the entire mortgage system at risk and raise costs for responsible borrowers.
By contrast, those who defend the strategic defaulters tend to view the banks as the ultimate cause of the housing market meltdown because they made the unwise loans and are unreliable partners with the government in HAMP.
But although the term ‘strategic default' is new, the concept is not, as the HOLC experience illustrates. In 1933 Congress designed the agency as a more aggressive bailout mechanism than anything we're doing now, to deal with widespread defaults during the era. The federal government empowered HOLC to buy up mortgages from banks and offer homeowners new, more affordable loans. To carry out the program HOLC created an enormous new workforce of its own loan officers, appraisers, auditors and other support personnel, totaling at full strength some 20,000 employees. They received 1.9 million requests from home owners for new mortgages and approved about one million of them.
Yet although HOLC made mortgages its loan officers thought would succeed, about 20 percent of the new loans defaulted anyway, a number not as high as the default rate with HAMP but still extraordinarily high. While some of those who failed to pay were victims of high levels of unemployment or other unforeseen circumstances during the Great Depression, the majority of those who defaulted, in the opinion of the bailout agency's loan officers and appraisers, were capable of paying but knew a good deal when they saw one.
An analysis of HOLC's records by Columbia University economist C. Lowell Harriss, published in 1951 by the National Bureau of Economic Research, found that HOLC personnel classified about 65 percent of all defaults as resulting from borrowers' "noncooperation" with the agency after receiving a new mortgage, or from an "obstinate refusal" to pay. "This type of noncooperation could sometimes be attributed to a desire to obtain free housing . . . an object that, in view of HOLC's nature, was not difficult to realize," Harriss wrote.
The equation was simple. Since HOLC didn't initially pursue homeowners in court who didn't pay up, because such a move seemed so unpopular during the Depression, defaulters understood they could live rent-free, sometimes for up to two years. When HOLC figured this out, the agency changed course and began filing legal actions to discourage more defaults and to move people more quickly out of the homes they never intended to save.
Why did so many homeowners of the era decide to default even on a deal that was better than what's being offered today's homeowners? One probable reason is that despite the massive effort, HOLC did little to revive the housing market in the face of high unemployment, and home prices stayed at depressed levels until the post-World War II boom revived them. Faced with the opportunity of paying off a home that wasn't increasing much in value and might never, a good number of homeowners opted instead to live rent free then get out. A rational investment decision, surely.
One thing that sets HOLC apart from today's bailout is that government was in control of the entire process back then. Critics of today's Fannie Mae policy say that the private bankers who are partners in the government's bailout program are unreliable and have little incentive to renegotiate loans. The critics worry that the loan services will just push people into court, instead.
Yet the HOLC loan officers gained nothing from foreclosing on homeowners, and still they ultimately decided that as many as 135,000 homeowners were an early version of the strategic defaulter. This shouldn't be so surprising. Incentives mattered then, and they still do.
