To Avoid Foreclosures, Try Forbearance

Little noticed since the end of the housing price bubble is how the primary cause of mortgage defaults has changed.

Three years ago the major cause of mortgage defaults was tied to the subprime mortgage mess. Private-sector mortgage originators lent money to borrowers who lacked the means to repay their loans. These borrowers counted on future price appreciation to enable them to refinance into loans that were more affordable. When the bubble burst, these borrowers were stuck with their unaffordable monthly mortgage payments and mortgage balances that exceeded the declining value of their homes.

In the spring of 2009, the government launched Hamp, which was intended to make these mortgages affordable by modifying their terms so that the monthly payments were permanently reduced to 31% of a borrower's current monthly income. However, by the time the government introduced its mortgage modification program, the characteristics of the typical borrower in delinquency had changed.

For the past couple of years the major cause of mortgage delinquencies and defaults has been unemployment. The evidence is the number of prime mortgage delinquencies that has exceeded subprime mortgages delinquencies during this period.

This turn of events should not come as a surprise to students of housing finance. In the prime mortgage space it is well understood that the main causes of mortgage defaults are tied to major adverse life events: divorce, serious illness or death, or the loss of a job. It was inevitable that the sharp rise in sustained unemployment would lead to an equally sharp rise in mortgage defaults unrelated to the subprime mess.

Sadly, Hamp was generally beyond the reach of these homeowners. A lender is only obligated to offer a Hamp modification when it is in the investor's interest, as defined by the program's net present value test. When household income has plunged because of job loss, the financial interest of the lender is better served by foreclosing.

However, homeowners who have lost their jobs do not want to walk away from their mortgage obligations. If they are delinquent or in default on their mortgages it is because they have lost jobs in this difficult period of high and sustained unemployment and do not have the income to make their monthly payments. They do not need permanent modifications to their mortgage terms. What they do need is forbearance on their monthly obligations for a reasonable period of time, during which they can find new jobs. An appropriate time frame is one that reflects the current job market in which it takes much longer to find reemployment than in the past. This problematic reality is the reason unemployment insurance payments have been extended to 99 weeks.

A proposal focusing on forbearance for unemployed homeowners put forward by Federal Reserve economists on the website of the Boston Federal Reserve more than two years ago. It anticipated the rise in mortgage defaults due to unemployment, and it was structured with commendable incentives. In the summer of 2010, the Treasury did introduce a short-term forbearance program, requiring participating servicers to offer three months of forbearance to qualified unemployed homeowners. Unfortunately, three months is far too short a period given the current job market, and anecdotal reports are that mortgage servicers are not offering the program.

Nevertheless, a well-structured forbearance program would likely save many homeowners from defaulting on their mortgages, and it would do so at a very modest cost. For example, a full year of forbearance for a mortgage with a monthly payment of $1,000 would only cost about $300 at current interest rates. In this difficult budget environment, it is unreasonable to expect that even the modest funding needed for such a program would come from the Congress.

Nevertheless, there is a potential source of funding. The state attorneys general are on the verge of an agreement with mortgage servicers to settle allegations of mishandling mortgage servicing and foreclosures. The amount of the anticipated settlement is reported to be in the neighborhood of $20 billion.

If some of these funds were used to support a well-structured forbearance program for unemployed borrowers they would be sufficient to help literally millions of unemployed homeowners and are likely to be the most effective way to prevent a large number of avoidable foreclosures.

Such a program would be a highly welcome turn of events for the entire housing market as well. In addition to the obvious pain that avoidable foreclosures cause homeowners, failing to keep people in their homes is particularly problematic for the entire housing market at this time.

The large number of distress sales on the market and the even larger number of anticipated foreclosures continues to put sustained downward pressure on home prices. If home prices were still at the stratospheric levels of the peak of the bubble, downward pressure on prices would be a healthy correction.

However, housing prices are now back to their long-term trend level and the needed correction in housing prices has taken place. Any further price declines will overshoot on the downside, depressing prices below their long-term equilibrium level, and unnecessarily adding to the broad-based loss of household wealth.

Forbearance for mortgage payments for unemployed workers would yield benefits for all by avoiding this outcome.