[Economic Report of the President (2012)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]


Stabilizing and Healing the Housing Market

The recession that began at the end of 2007 is inextricably linked with
the bursting of the housing bubble that had built up over the previous
decade. The ensuing shock to financial markets, and the more than $7
trillion in lost housing wealth, prolonged and deepened the downturn and
has been a headwind for the economic recovery. Although the housing
market is showing signs of stabilization, the healing process is not
complete in many parts of the country.
The bursting of the bubble was a culmination of a multiyear
process of rapid growth in house prices fueled by excess capital flows
into the United States. These flows were converted into home mortgages
by various financial intermediaries using lax underwriting standards
and channeled through the financial system with an increasingly complex
web of mortgage securitizations. These trends, in turn, created unmoored
expectations of continuous price growth that caused a spike in
residential construction. The overheated housing market ultimately
proved to be unsustainable, and the return to more realistic levels has
been very painful for the economy. As this process continues to unfold,
responsible policies are needed to assist the market in its transition
to a new, sustainable equilibrium supported by a prudent and robust
financial framework. In this context, healing the housing market
requires laying the foundation for balanced and sustainable growth,
while repairing and improving the housing finance system that helped
inflate the housing bubble.
The effects of the drop in housing prices have been amplified
by the uniqueness of housing as a financial asset class. Indeed, housing
is the single most important asset for a majority of American
households. Houses generate a steady stream of consumption services for
their owners, as well as enabling them to send their children to local
schools and use neighborhood amenities ranging from parks to retail
stores to hospitals. They also create demand and jobs as homeowners
furnish their homes and invest in their


maintenance. By virtue of their tangibility, houses also serve as an
important form of collateral for other borrowing purposes, notably
startup financing for small businesses. Housing collateral attracts
lender financing, making housing the most levered asset in household portfolios and closely linking the health of the housing market to that
of the broader financial sector. Consequently, declines in housing
wealth can have a far greater effect on the economy than equivalent
losses in other financial assets, such as equities.
Setting the housing market back on track is a key step on the
road to recovery. Yet housing presents several particular challenges,
many of which derive from an array of institutional frictions in housing finance markets that have been exposed by the enormous scale and scope
of home price declines and from very long lags in the adjustment in the
stock of housing. This chapter highlights some of these challenges. They include a poorly functioning system for loss mitigation of nonperforming mortgages and effective disposition of mortgaged properties; inadequate origination of mortgage credit; and obstacles to refinancing, including
the widespread phenomenon of negative equity. These deficiencies form a mutually reinforcing adverse feedback system in which negative equity
raises the likelihood of delinquencies that often result in a drawn-out foreclosure process, eventually concluding with distressed sales that
exert further downward pressure on home prices and thereby deepen the
amount of negative equity. The large overhang of unresolved properties
in distress, along with mortgage debt in excess of home value, further
feeds this negative dynamic by depressing price expectations of
potential homebuyers and lenders. Left unchecked, this dynamic creates a dangerous possibility for housing prices to overshoot and fall below
their fundamental values, posing a difficult hurdle for sustained
economic recovery.
Some have argued that the best course of action is to rely on
the market alone to work out the problems of struggling homeowners,
negative equity, and foreclosed properties through liquidation. This
approach disregards the risk of overshooting the bottom, and it fails
to recognize the many complex incentive conflicts that exist between
purely private parties, such as homeowners, investors, and mortgage
servicers. These conflicts and the need to recognize and allocate
housing losses to various economic actors, present a serious collective
action problem, the resolution of which by the market has been sluggish,
at best, over the past several years. Perhaps most important, a
laissez-faire approach also disregards the spillover effects of large
numbers of delinquencies and foreclosures on local housing markets, the financial system, and the toll they exact on American families and the
economy in general.

100 |   Chapter 4

The alternative to sitting back and waiting for these enormous challenges to work themselves out slowly and painfully is for the
Government to engage in a series of coordinated, measured, and
multifaceted policy actions. This approach involves working in
conjunction with market participants and housing regulators to address
the lingering effects of the bursting of the housing bubble, as
suggested, for instance, in a recent Federal Reserve Board white paper
(2012). This chapter describes a set of existing and proposed policy initiatives that target many of the interlinked housing market problems.
Some of these policies are pursued through Government agencies, such
as the Federal Housing Administration (FHA), the Department of Housing
and Urban Development (HUD), and the Department of the Treasury. Others
are undertaken in conjunction with private investors, and still others
are carried out together with the government-sponsored enterprises
(GSEs), Fannie Mae and Freddie Mac, under the supervision of their
regulator, the Federal Housing Finance Agency (FHFA).


After growing at a rapid pace through the early years of the new century, home price appreciation ground to a halt in the summer of 2006.
This change in the path of housing prices triggered an initial wave of subprime mortgage defaults, and the resulting losses quickly propagated through the global financial system, bringing it to the brink of
collapse and ushering in a deep recession. By the beginning of 2009, nationwide measures of home prices had declined for 30 straight months, falling by a total of nearly 28 percent. This drop in the national
average masks significant regional variation. In some states, like
Florida and Nevada, where prices had gone up the fastest, housing
prices plummeted by 35 to 50 percent from their peak. Price drops in
some other states were much milder.
Overall, as shown in Figure 4-1, the decline in inflation
-adjusted home prices was unprecedented in the post-World War I U.S.
economic experience in both its severity and its geographic scope.
Some of the regional housing recessions--notably in California and
New England in the early 1990s--generated sharp and long-lasting price declines, but neither was as steep and prolonged as the current
episode. And during the Great Depression, the only other instance of nationwide price declines since WWI, much of the comparably-sized
decline in nominal home prices was offset by a concurrent drop in
general price levels, so the decline in real housing values was only
about one-quarter as large as the one we recently experienced.

Stabilizing and Healing the Housing Market   | 101

The unprecedented and ultimately unsustainable nature of housing market trends before 2007 is further highlighted in Figure 4-2. The
dashed line depicts annualized growth in real levels of mortgage debt per homeowner household between 1991 and the third quarter of 2011.
Mortgage debt balances grew at a rapid pace from 2001 to 2007, one that
far exceeded growth in real income during this period. There were many
factors behind the escalating household debt. In part, it reflected
rising home prices and growing household leverage driven by extraction
of home equity and shrinking down payment requirements. As households continued to accumulate mortgage debt in the expectation of ongoing
housing appreciation, housing was becoming less and less affordable, as evidenced by the price-to-rent ratio series (the sold line) in the same figure. After remaining in a narrow range between 100 and 120 percent
for nearly two decades, the price-to-rent ratio accelerated rapidly to
peak at 186 percent in the first quarter of 2006.
Once the bubble burst, falling prices and poor economic
conditions resulted in steep increases in delinquencies and
foreclosures across a broad spectrum of American homeowners. By the
first quarter of 2009, non-performance rates among prime borrowers rose
nearly threefold relative to their level in the first quarter of 2005
(from 2.2 to 6.1 percent), while those for subprime loans spiked to
nearly 25 percent, from 10.6 percent four years earlier. About 1.7
million homes were at some stage of the foreclosure

102 |   Chapter 4

process, and nearly 7 percent of total mortgage debt was seriously
delinquent (more than 90 days past due). Market participants were deeply pessimistic about the future path for housing prices-the Case-Shiller
index futures contracts traded in January of 2009 suggested that house
prices were expected to fall an additional 10 percent by September 2010
(the dashed line in Figure 4-3). Other housing futures contracts traded
in over-the-counter markets (not shown) were even more downbeat.

Initial Policy Responses to the Crisis

The broad meltdown in the financial sector called for a series
of emergency responses by the Executive Branch, the Legislative Branch,
and the Federal Reserve. The Federal Reserve undertook a series of
aggressive monetary policy actions and launched a number of programs
to support liquidity and lending activity in key financial markets.
Congress passed the Housing and Economic Recovery Act (HERA) in July of
2008, which established the Federal Housing Finance Agency, the new
regulator of the GSEs with greatly expanded powers. The HERA was
followed by the Emergency Economic Stabilization Act in October of 2008,
which established the Troubled Asset Relief Program.
In one of its first major policy actions, the Obama
Administration implemented the Financial Stability Plan in February
2009. A key part of

Stabilizing and Healing the Housing Market   | 103

the plan focused on maintaining the flow of housing credit and helping responsible homeowners stay in their homes through the Making Home
Affordable (MHA) program. In particular, the Treasury Department made
an increased funding commitment to Fannie Mae and Freddie Mac, which had
been placed in conservatorship six months earlier. The Federal Reserve,
which had previously announced a program to purchase up to $600 billion
of GSE debt and mortgage-backed securities, expanded the planned size of
the program to $1.75 trillion in March 2009. These actions have resulted
in economically meaningful and long-lasting reductions in mortgage
interest rates (Gagnon et al. 2010) and credit availability (Fuster
and Willen 2010).
To help responsible households take advantage of these lower
rates, the MHA included the Home Affordable Refinance Program (HARP),
which was intended to enhance refinancing opportunities for borrowers
who had insufficient equity in their homes. While HARP helped homeowners
to hold onto their homes through more sustainable mortgages, other
components of the MHA focused on restructuring mortgages of borrowers struggling to stay current on their loans. In particular, the Home
Affordable Modification Program (HAMP) provided a streamlined approach
to modification of delinquent loans and offered monetary incentives and procedural safe harbors to industry participants. To help communities
manage the destruction caused when the housing market collapsed, the
American Recovery and

104 |   Chapter 4

Reinvestment Act of 2009 (the Recovery Act) provided additional support to the housing market by extending HUD's Neighborhood
Stabilization Program, which began under HERA. This program allocated
funds to state and local governments and nonprofit organizations to
mitigate foreclosures and to pursue innovative local approaches to deal
with the economic effects of abandoned properties. The Recovery Act
extended the first-time home-buyer credit established under HERA and
increased it to $8,000. This program was extended further by the
Workers, Homeownership, and Business Assistance Act of 2009.
To date, these initial responses to the housing crisis have
assisted several million households. The most recent housing scorecard released by the Department of the Treasury and HUD indicated that, as of December 2011, more than 930,000 homeowners had received permanent modifications under HAMP, putting the program on pace to reach the 1
million threshold early in 2012. Of equal importance, HAMP provided a
template for major servicers to follow in conducting their own
modifications outside of the program. To date, servicers have undertaken nearly 2.7 million so-called "proprietary" modifications, many of which
would not have occurred without the standards established by HAMP. The scorecard also highlights 998,000 loans refinanced though HARP, as well
as nearly 1.2 million borrowers helped through various FHA loss
mitigation interventions. These programs have faced challenges from a
number of structural problems in housing markets. These problems include incentive conflicts that arose when loan servicing was separated from
loan ownership in mortgage securitizations, as well as uncertainty about
legal liability in loan origination and loss mitigation practices. These problems have been greatly exacerbated by erosion in collateral values,
which have increasingly fallen below the value of associated loans and
put more than one in five mortgage borrowers "under water." These
dramatic declines in collateral necessitate eventual recognition of
economic losses and allocation of such losses to various economic
actors. As policymakers have increasingly focused on addressing these deficiencies, each of these original MHA programs has undergone
substantial modification, described more fully in the following

Negative Equity: An Unprecedented and Pervasive Problem

As noted, widespread declines in housing prices resulted in
more than a $7 trillion fall in aggregate housing wealth. These losses
were borne to at least some extent by most homeowners. For some
homeowners, however, falling prices not only wiped out their housing
wealth in its entirety but also pushed the value of their homes below
the value of outstanding mortgages. The resulting "negative" equity,
which is estimated to total $700 billion, has

Stabilizing and Healing the Housing Market   | 105

become one of the legacy hallmarks of the housing price bubble. This
negative equity resulted from large home price declines combined with
a number of other factors. According to recent estimates, as many as
10.7 million (or 22 percent of) borrowers are under water. The
aggregate negative equity is unequally distributed across the nation.
Six states with the highest incidence of negative equity-Arizona,
California, Florida, Georgia, Michigan, and Nevada--account for more
than half of all underwater borrowers and of the aggregate amount of
negative equity (Figure 4-4). All of these states have experienced steep declines in house prices.
Negative equity has been associated with a number of problems
over and above those caused by the more widespread loss in housing
wealth. Underwater borrowers find it difficult, if not impossible, to
take advantage of record low interest rates through refinancing, because lenders and investors are unwilling to take on uncollateralized credit
risk. The inability to refinance prevents households from lowering
their monthly mortgage payments. It also undermines the effectiveness
of monetary policy that aims to lower borrowing costs to businesses and households and thus encourage greater economic activity. (For more on
the decision to refinance, see Economics Application Box 4-1).
Underwater households have weakened incentives to invest in
their property, since the expected gains from their investment are
likely going to be absorbed by the lender. As a result, underwater
households underinvest

106 | Chapter 4

in home improvements and maintenance, which leads to the overall decline in the quality of the nation's housing stock (Melzer 2010).

Negative equity has also been associated with heightened
realized default rates. Several recent academic and industry studies
have found that the higher their negative equity, the more likely
households are to become delinquent (Bajari, Chu, and Park 2010;
Elul et al. 2010). Recent work by Federal Reserve Board economists
(Bhutta, Dokko, and Shan 2010) shows that a household's equity position amplifies the effect of unemployment shocks on default and that this interaction grows in strength with the degree of negative equity.
(For more on data challenges in evaluating the financial situation of homeowners, see Data Watch 4-1). Household delinquency and the ensuing foreclosures are very costly, as they disrupt the social fabric of neighborhoods and cause lenders to engage in an expensive and
drawn-out process of liquidation. Moreover, foreclosures not only lower
the value of the foreclosed property itself; they also have a sizable spillover effect on valuations of neighboring homes. According f to a
recent academic study (Campbell, Giglio, and Pathak 2011), each
foreclosure within a 0.1 mile radius of a given house lowers its
predicted sale price by 7.2 percent.
Negative equity also poses a roadblock for efficient reallocation
of housing resources. Families naturally buy and sell houses over their
life cycle and in response to shocks such as illness or divorce. The
necessity to write a sizable check to the lender upon sale makes it effectively impossible for liquidity-constrained households to trade
their houses without credit-impairing actions such as delinquency;
deed-in-lieu, in which a borrower returns the property to the lender;
or short sale, in which a house is sold for less than the balance of
debts secured by the property. Negative equity also has the potential
to limit underwater borrowers' ability to pursue employment
opportunities in other geographic areas. The empirical evidence to date, however, has largely suggested that the adverse effect of negative
equity on labor mobility--the so-called "house lock effect"--is fairly


The housing sector plays an important role in determining the
health of the broader economy. Two aspects of this relationship are particularly important-the effect of housing wealth on household
consumption and the direct contribution of residential construction
to gross domestic product (GDP).

Stabilizing and Healing the Housing Market   | 107
Economics Application Box 4-1: Making a Decision about Refinancing a

Mortgage rates in the United States reached historic lows in
2011, presenting an opportunity for many homeowners to save money by refinancing their fixed-rate mortgages. However, refinancing
typically involves a number of costs that push the effective interest
rate above the rates reported in news media. These costs include those associated with obtaining a new loan, such as title insurance and
various administrative fees; risk-management charges related to loan origination (for example "points"); underwriting charges for appraisal
of the house; and the more mundane costs of gathering documentation.
How does a homeowner decide whether it is worth paying the
additional costs to reap the benefit of the lower rate? The first step
in evaluating refinancing is to get a clear and comprehensive summary
of costs associated with a new loan; these should be provided by your
loan officer or mortgage broker on a HUD-1 form. While many of these
costs can be rolled into the loan, some have to be paid in cash up front.
The second step is to lay out the stream of all payments
required under the original loan and the new loan used for refinancing. Although this process may seem involved, it will allow you to take into account refinancing costs as well as the fact that you will be making
payments on a refinanced mortgage over a longer period than you will
have remaining on the existing mortgage.
Third, those payment streams need to be converted into one
number-the amount of spending today that this stream of payments is
worth. This is known as the net present value or NPV. The net present
value discounts costs paid in the future to reflect the time value of
money and the uncertainty associated with future returns. In the
simplest possible form, it is better to have a dollar today than a
dollar tomorrow, as this dollar can be invested and grow in value by
the time tomorrow arrives. Hence, all future payments are discounted
relative to today's outlays. The choice of the discount rate merits a
separate discussion that is beyond the scope of this example. However,
some common choices include discounting at the risk-free rate (commonly
approximated by the 10-year Treasury rate) or the expected rate of
return for the stock market (approximated, say, by the long-term average return on the S&P 500 index). The NPV calculation can be carried out
with a spreadsheet program such as Microsoft Excel or on a number of
websites. Once NPV values are computed for both payment streams, the one
with the lower value is the better choice.

108 | Chapter 4

The computation and comparison of net present values is the main idea behind a broad range of online calculators designed to answer the question of whether refinancing makes sense. An example can be found on Jack Guttentag's Mortgage Professor's Website at http://www.mtgprofessor.com/calculators/Calculator3a.html. Some mortgage brokers are fond of making use of simple rules of thumb as a shortcut for using the NPV approach. For example, they may suggest that "the new
mortgage rate has to be 1 percentage point lower to justify refinancing
with typical closing costs." Recent estimates of such rule-of-thumb
threshold differences in interest rates have varied between 1 and 1.5 percentage points.
One often overlooked cost of refinancing has not yet been
mentioned. By refinancing today, one generally forgoes the opportunity
to refinance in the future if interest rates were to drop a bit
further. Suppose you determine that refinancing a 5.75 percent loan
into a 4.5 percent loan is advantageous from an NPV standpoint. Then refinancing the original loan into a 4.25 percent loan would be even
more beneficial, but refinancing from a 4.5 percent loan would not. This difference between payments at 4.5 percent and 4.25 percent is
essentially the value of the forgone option to delay refinancing. The
value of preserving this option has fluctuated over time, because it
clearly depends on the volatility of interest rates, the economic
outlook, and the ability to maintain access to credit markets-a
nontrivial concern for today's borrowers.
In recent work, Sumit Agarwal, John Driscoll and David Laibson
(2007) calculated the optimal interest rate differential at which to
refinance that explicitly takes into account the aforementioned option
value (these calculations can be found at
http://zwicke.nber.org/refinance/). Take, for example, a family that
plans to stay in their house for 10 years, has a $250,000 mortgage
at 6 percent interest rate and has a marginal tax rate of 28 percent.
For this family, assuming an upfront fee of 1 percentage point of
mortgage value (1 point) and cash closing costs of $2,000,
refinancing is optimal if the interest rate on the new mortgage is
4.6 percent or less. Unlike the simple rule of thumb, this
calculation takes into account family expectations of the future
inflation rate, interest rate volatility, and how long they plan to
stay in the house--the option value determinants--which affect the
ultimate recommendation.

Stabilizing and Healing the Housing Market   | 109

Consumption Effects

The standard approach in economics has been to assume that
households consume about the same fraction of the increase in their
wealth each year, regardless of its source. Numerous econometric studies
have come up with a range of estimates that relate changes in household consumption to changes in wealth (Poterba 2000). Although there is no
single agreed-upon value, the consensus range is fairly narrow-the
fraction of each additional dollar in wealth consumed in a given year
(what economists call the marginal propensity to consume out of wealth,
or MPC) is estimated to be roughly between three and five cents.
Applying the lower of these estimates to the $7.25 trillion in housing
wealth losses to date implies consumption losses of $218 billion a
year, or 1.5 percent of GDP. Under standard Okun's law assumptions,
this GDP impact, in turn, translates into a 0.75 percentage point
increase in the unemployment rate. The severity of losses experienced
during the recession that began in December of 2007 in both national
output and in labor markets makes these estimates appear too small.
One of the possible explanations for this puzzle may be that
declines in housing wealth have a more profound effect on consumption
than equivalent declines in other forms of wealth. Case, Quigley,
and Shiller (2005, 2011) find strong empirical evidence in support of
this hypothesis by exploiting substantial variation across states in
house price paths and holdings of equity assets. In particular, they
relate quarterly growth rates in house prices and equity holdings
to quarterly growth rates in state-level retail sales and find that the consumption response is more sensitive to changes in housing wealth
than to changes in stock market wealth. It is noteworthy that both the
level of the response and the difference between sensitivities to
financial and housing wealth shocks increase substantially once the
recent experience is incorporated in the data (the 2011 study includes
data from 2000 through 2010.)
Why would households respond more to housing wealth shocks?
Part of the likely answer has to do with the very different
distributions of ownership of various financial asset classes. Most
financial assets other than liquidity-restricted retirement plans are
heavily concentrated at the top of the wealth distribution. In contrast, holdings of housing assets are much more uniformly spread across
different wealth, income, and demographic strata. At the peak of the
housing market in the third quarter of 2006, home ownership stood near
a record high at 69 percent. Although home ownership rates among African American and Hispanic households were noticeably lower (49 percent and 50 percent, respectively), they vastly exceed ownership rates of all other financial assets other than bank accounts for these two groups. Perhaps
more important, housing assets make up a much

110 | Chapter 4

Data Watch 4-1: Need for a Comprehensive Source of Data on Mortgage Debt and Performance

There are currently four basic sources of loan-level data on
mortgage debt: the Home Mortgage Disclosure Act (HMDA) database, data
reported by mortgage servicers, credit bureau data, and public records
data. Each of these sources provides insight about mortgage holdings,
but the existing system is inadequate for measuring the extent and
ownership of financial obligations backed by residential real estate.
The HMDA database contains data required to be publicly reported
for all mortgages. It is useful for measuring long-term trends in
mortgage application volumes and originations, but contains little
information on loan terms or performance following origination. Further,
HMDA data are released only annually with a significant lag. In contrast, proprietary data sets from loan servicers, such as Lender Processing
Services (LPS) and CoreLogic, have useful information on loan
characteristics and performance but underrepresent certain loan and
investor types. They also have little detail on borrower income or
credit scores following origination and lack information on other debt obligations, including those collateralized by the same real estate.
The credit bureau data track borrower credit scores and
performance on multiple debt obligations over time, but tell us little
about loan terms and mortgage contract type and nothing about the
employment status and current income of homeowners. Public records
contain legal notices of property-related transactions, such as mortgage origination and foreclosure, but they contain little information beyond
the reason for creating the record, loan amount, and an associated
property identifier.
Linking these data sources to produce a more comprehensive
database is a challenging undertaking, but a pilot version developed
by a team of researchers at Freddie Mac and the Federal Reserve Board
has laid a strong foundation for this effort. A combined database could
make available critical statistics on the health of the housing market.
For example, it could establish a link between first- and second-lien mortgages on the same property, providing key information on the
overall extent of borrowers' leverage in different housing markets.
This, in turn, would enable better risk management by first-lien
lenders and private investors, as well as better design and
implementation of government and private-sector loss mitigation
programs. In addition, by utilizing statistical sampling techniques,
such a database could correct for known biases across different data
sources. Reliance on sampling also could reduce operational burden,
allowing for more timely reporting.

Stabilizing and Healing the Housing Market   | 111

larger fraction of wealth among lower income households. Whereas housing accounted for nearly two-thirds of the overall assets of households in
the bottom half of the wealth distribution in 2007, it constituted only
25 percent of assets for those in the top decile, and only 10 percent
for those in the top percentile. Shocks to housing wealth not only
affect more households than other wealth shocks; they also apply disproportionately to those at the lower end of the wealth
A Pew Research Center report issued in July 2011 provides a
stark illustration of these trends, concentrating on the disparate
effects of the burst housing bubble on the wealth of minority and white households. Because home equity accounts for a much greater share of
household wealth among minorities-59 percent for African Americans and
65 percent for Hispanics in 2005, compared with 44 percent for
whites-minority households experienced much greater losses from the
housing downturn. These losses were further compounded by the uneven geographic distribution of house price declines. As underscored by the
Pew report, more than 40 percent of the nation's Hispanic households
resided in the five states with the steepest price drops-Arizona,
California, Florida, Michigan and Nevada-while only about one in five
of all white and African American households resided in those states.
For Hispanics in those five states, declining home prices have nearly
wiped out household net worth, with median values collapsing from about $51,000 in 2005 to just $6,000 in 2009.
These trends matter to consumption because empirical research
has pointed out systematic differences in marginal propensities to
consume across income groups. For example, studies that analyzed the consumption effects of the 2001 and 2008 tax rebates using actual
household expenditure data found that low-income households and those
with low liquid wealth spent considerably higher fractions of these
rebates. These effects were identified in credit card data (Agarwal,
Liu, and Souleles 2007), the multiple-category Consumer Expenditure
Survey (Johnson, Parker, and Souleles 2006), and automobile purchases
(Parker et al. 2011). The fact that housing wealth losses were
concentrated among the subset of households most responsive to such
shocks may account in part for the magnitude of the observed declines
in consumption. Indeed, a recent study by Mian, Rao, and Sufi (2011)
shows that households with low levels of nonhousing financial assets experienced much greater declines in consumption for a given decline
in home prices.
A growing economics literature highlights the importance of
house-hold debt balances in influencing the severity of economic slumps.
Most of the growth in household debt between 2002 and 2006 can be
traced to mortgage-related borrowing, which increased by nearly $5
trillion (or 94 percent of the total increase) over this period. As
housing values collapsed,

112 | Chapter 4

many households found their balance sheets tilting heavily toward debt. Household efforts to bring their balance sheets closer to equilibrium
leverage can potentially proceed along several avenues. Households can
default on their debt obligations. They can accelerate repayment of
their debts. Or they can repair their asset base through more aggressive saving. Collectively, these approaches are often referred to as
A series of empirical papers attempts to quantify the effect of
such deleveraging on consumption (Mian and Sufi 2010; Mian, Rao, and
Sufi 2011). These papers broadly suggest that the levered nature of
household housing assets amplified the effect of pure wealth losses from
the crash in housing prices. The studies compared the consumption
response in counties with different pre-recession levels of household
debt and found that counties with the highest debt levels experienced
much larger and longer-lasting drops in consumption than counties with
low debt levels. This finding held true for consumer durables, such as automobiles, appliances, and furniture, as well as for consumption of groceries. These counties also exhibit patterns consistent with
deleveraging, as increases in the numbers of defaults, and debt paybacks
by non-defaulters are much higher in high-debt counties than in low-debt
ones. These trends in consumption in turn affect local employment, particularly in sectors that produce locally consumed goods and
services, such as restaurants and retail establishments (Mian and
Sufi 2011). Figure 4-5 illustrates the divergence in employment trends
in such nontradable industry sectors for high- and low-debt counties.
In contrast, the traded goods sectors (not shown) display no such
divergence, suggesting that the run-up in debt and bursting of the
housing bubble have caused the contraction in aggregate demand.
Aside from the consumption effects of debt reduction or
increases in savings needed to deleverage, households with impaired
balance sheets may also have difficulty obtaining credit, which would
further affect their consumption (Hall 2010). Before the crisis, the
ability to use home equity as loan collateral served as an important
source of financing for household purchases of goods and services.
For example, Doms, Dunn, and Vine (2008) find that the increasing
ease of tapping home equity credit in the early 2000s allowed
homeowners to use their housing wealth to finance various forms of consumption. Another example of the pernicious effects of over-
leveraging on access to credit, discussed earlier, is the inability of
homeowners with low or negative equity stakes to refinance into
low-interest mortgages. Moreover, reductions in the collateral value
of houses have a negative effect on the economic recovery by restricting
one of the primary channels for financing startup businesses.

Stabilizing and Healing the Housing Market   | 113

Residential Construction and Home Ownership Patterns

As discussed in Chapter 2, residential construction in 2011
remained at very subdued, albeit stable, levels. Starts of new housing
units averaged a little over 600,000, roughly in line with the levels
observed in 2009 and 2010. Housing starts of both single- and
multi-family structures remain far below their peak 2006 levels of 2
million units, weighed down by the cyclical weakness in demand, the
slow pace of household formation, high inventories of vacant properties
for sale, and tight financing conditions for homebuilders.
In addition to cyclical headwinds, residential construction
has been impeded by the need to reallocate the nation's housing stock
from owner-occupied to rental units, as a growing number of households
exited the ranks of homeowners through foreclosures. Recent research by Federal Reserve economists analyzes the moving decisions of homeowners
who went through foreclosure between 1999 and 2010 (Molloy and Shan
2011). This study finds that post-foreclosure households do not tend
to move in with others to defray their living expenses. Rather, the overwhelming majority of them (76 percent) end up renting single-family housing units.
This evidence suggests that many of the newly foreclosed
households will continue to exhibit strong preference for single-family structures. However, the conversion of an owner-occupied house to a
rental property takes a certain amount of time, especially if the home
is repossessed at the

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conclusion of the foreclosure process. Repossessed homes need to be
sold, often rehabilitated, and then marketed to potential renters. This process is made all the more difficult by tight credit conditions for financing investment properties, evidenced by historically high shares
of all-cash purchases and by execution problems in amassing property portfolios necessary to realize any economies of scale through multiple foreclosure auctions.
In the meantime, prices in rental markets have been trending
upward, pointing to the critical importance of efficient conversion of foreclosed properties and providing some of the necessary impetus for
this process. A well-functioning mechanism for disposition and conversion
of distressed properties into rental units has the potential to ease the downward pressure on owner-occupied house prices by removing a part of
bank-owned and shadow inventory of soon-to-be-foreclosed properties from
the sales market. (See the Data Watch 4-2 for discussion of challenges
in measuring home sales.)
Demand for rental housing is likely to grow at a healthy rate
over the next few years, creating an ongoing need to convert existing
homes to rental. First, household formation is poised to accelerate. As numerous observers have pointed out, household formation slowed
dramatically during the 2007-09 recession and has only recently begun
to grow. Data from the Census Bureau show formation of fewer than
400,000 new households in both 2009 and 2010, well below the 2002-07
annual average of 1.3 million. The primary part of this trend is
cyclical, deriving both from high unemployment rates among the young
and from a substantial drop-off in immigration. A 2010 study done for
the Mortgage Bankers Association (Painter 2010) suggests that
historically, as economic conditions improved, individuals who delayed
forming households during recession years were more likely to turn to
rental markets to fulfill their housing needs.
Second, credit conditions have tightened considerably in
recent years. Successful mortgage applicants have substantially higher
average credit scores and are required to put up larger down payments
than was the case in the era of rapidly rising house prices. For
potential homebuyers who are unable to put down 20 percent of the
purchase price, loans through the FHA and the U.S. Departments of
Veterans Affairs (VA) and Agriculture have become the primary and, in
many cases, only avenues for mortgage financing--providing a vital
counter-cyclical buffer to sustain access to credit through the
crisis. Consequently, the agencies' market share has risen rapidly,
with the FHA accounting for nearly 40 percent of all house purchase
loans in 2010. Among minority households, in particular, the FHA and
VA loans became the predominant form of financing for home purchase.
Between 2005 and 2010, the share of FHA/VA loans has skyrocketed from

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Data Watch 4-2: Need for a Comprehensive Source of Data on Home Sales

On December 21, 2011, the National Association of Realtors
(NAR) announced substantial downward revisions going back to 2007 of previously reported data on sales of existing homes. The revisions
reduced the estimated home sale projection for 2011 from nearly 5
million units to 4.25 million units, and reduced the number of reported
home sales between 2007 and 2010 by nearly 3 million units. Although
the implied pace of change in recent home sales was largely unaffected,
lower sales levels caused a reevaluation of housing market conditions,
and, by causing realtor commissions to be revised downward, are
expected to lower the level of GDP.
To a certain extent, revisions to the NAR data are inevitable.
The NAR sales estimates are based on reports from a subset of regional Multiple Listing Services (MLS). The data from the covered areas must
be weighted to represent the areas that are not covered and adjustments
must be made to this weighting over time. Further, the NAR cannot
directly measure sales transactions conducted outside of Multiple
Listing Services platforms. These "unlisted" transactions may include houses sold by owners without realtor assistance, sales carried out by builders, and some foreclosure sales. These sales channels vary in importance over the housing cycle and across different geographies, something that can be difficult to capture accurately on a current basis.
NAR revisions also reflect the fragmented nature of local MLS
systems and their evolution over time. Historically, many metropolitan
regions were represented by several MLS databases. The NAR obtained
actual sales data from a subset of these databases and adjusted the
numbers to account for sales recorded in the remainder. MLS systems have undergone considerable recent consolidation. As NAR adjustments lagged consolidation of MLS systems, reported sales were being grossed up by
outdated factors and thus were systematically overstated.
Since all property sales are publicly documented by local deed registration systems, it theoretically should be feasible to use these
records to estimate sales volumes across all jurisdictions and all
channels, and with minimal time delay. The main hurdle to constructing
a comprehensive national data source for real estate transactions will
be to integrate data across disjointed and dissimilar county-level
recording systems. Such data, however, would represent a reliable and
timely source of information on sales activity-useful information for
macro-economic forecasters and an important gauge of health in the
nation's housing markets.

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15 percent to 80 percent of all purchase mortgages originated to African-American households and from 8 percent to 75 percent of all purchase
mortgages originated to Hispanic households. During the past three years,
at least 60 percent of all first-time home buyers financed their
purchases with FHA or VA loans. Young households surveyed by Fannie Mae repeatedly cite an insufficiently strong "credit history" and "not
having enough for a down payment" as two of the biggest obstacles to homeownership.
Third, younger households that just experienced a historic
decline in housing prices may be less optimistic about homeownership.
Recent research (Malmendier and Nagel 2011) showed that households
coming of age during periods of sizable declines in the equity market
stayed away from equity ownership in the future. For such households, a
longer lifetime perspective could not offset the dramatic price declines experienced early in life, which thus tended to have a strong and
long-lasting influence on subsequent economic behavior. It is premature
to say whether a similar "Depression babies" effect is applicable to
today's young renters. The scant survey evidence available on this
question is mixed. On one hand, the Fannie Mae surveys indicate that
the majority of young households continue to regard housing as a good financial investment and homeownership as a desirable goal. On the other
hand, a series of special supplements to the Michigan Survey of Consumer Sentiment suggest that younger households hold more pessimistic views of homeownership, although this result is limited to a subset of responders
with personal knowledge of someone who experienced foreclosure or
substantial home price declines (Bracha and Jamison 2011).
In sum, the weakness in the housing sector continues to weigh
heavily on macroeconomic performance. The enormity of losses in housing
wealth and the uneven distribution of those losses in the population,
along with the substantial weakening of household balance sheets
burdened by debt overhang, have an outsized effect on consumption. High unresolved inventories of distressed properties, along with a
concurrent need for large-scale rebalancing of the housing stock,
contribute to ongoing difficulties in the residential construction
These challenges are compounded by several structural problems
in housing markets that have been exposed by the crisis. Understanding
and addressing these institutional frictions represents a necessary
step in formulating appropriate policy actions.


The shock to the housing market laid bare serious deficiencies
in the existing infrastructure for servicing delinquent mortgage loans, liquidating

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foreclosed properties, and adjudicating legal disputes between various parties. These deficiencies have impaired the effectiveness of loss
mitigation efforts and may also be affecting borrowers' ability to
access mortgage credit.

Adjudicating Legal Disputes

Rapid growth in the volume and complexity of securitized
mortgage credit during the bubble years outpaced developments in case
law adjudicating legal liability for representations and warranties
associated with loan underwriting. The resulting legal uncertainty has
the potential to impede origination of new mortgage credit if it
unnecessarily adds to lender liability vis-a-vis mortgage investors.
During the standard loan origination process an underwriter
provides legally binding representations and warranties (R&W) backing
the veracity of collected information. Representations and warranties encompass such crucial elements of the loan application as borrower
income, available assets, and the appraised value of the house. Within
a specified period of time following securitization, an agent of the
investors (the Trustee) conducts a postsale audit of loan documentation.
If the Trustee finds R&W violations on a particular loan, the
originator is obligated to buy back that loan from the securitized
pool. A similar audit may be conducted in the event of mortgage
default, when the discovery of R&W violations on defaulted loans would
also result in the investor "putting back" the loan to the
originator. These put-back rights create a liability for originators
that is designed to serve an important quality control function: the originator must bear the risk of loss on defaulted loans with R&W
As the number of intermediaries between the underwriter and
loan investor grew, the transmission of this liability by each party
along the chain became less well understood, and quality control
standards became more difficult to enforce. For example, many financial institutions increasingly relied on independent mortgage brokers to
carry out customer prospecting and loan underwriting, especially in
urban and minority-dominated neighborhoods that have been historically underserved by traditional lenders. Because mortgage brokers did not
have sufficient capital to originate and hold a substantial number of
loans, they quickly sold their mortgages to a larger financial
institution, which, in turn, would securitize the resulting loan
portfolio in broader capital markets. In effect, mortgage brokers
functioned as independent contractors for banks that would eventually securitize these loans. In a twist on a common description of mortgage securitization, "originate-to-distribute," this business model was
labeled as "outsource-to-originate-to-distribute."

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In theory, established financial institutions that securitized
loans had ample incentives to exercise due diligence. They retained
liability for representations and warranties, and carried reputational
risk, as well as the risk that they might not be able to pass faulty
loans back to the originating mortgage brokers. Yet, there is empirical evidence that at least some banks actively securitized loans originated
by mortgage brokers with little or no documentation-the so-called
"liar" loans that can be easily falsified (Jiang, Nelson,
and Vytlacil 2011). The lengthening of the chain of financial
intermediaries made the evaluation and assignment of liability for
faulty underwriting processes considerably more complicated.
The complexity of the claims, and the sheer number of lawsuits
that are being litigated on a loan-by-loan basis, suggest that court resolution will take considerable time, which poses a challenge to
stabilizing the housing market and accelerating a recovery.

Incentive Conflicts

Before securitization became prevalent, the majority of
mortgages was funded directly by banks and other deposit-taking
financial institutions. These loans were held on lenders' own
balance sheets and were typically serviced by them as well.
Securitization of mortgage credit either through GSEs or private label
issuers allowed the expansion of funding to broader capital markets.
As a result, bank-funded (or portfolio) mortgages became less prevalent, ceding ground to GSE and private-label securitizations (PLS). By 2007,
the share of aggregate residential mortgage debt held on portfolio had
fallen to 37 percent from 48 percent in 1992, while that held by the
PLS investors nearly quadrupled to 19 percent over the same time period. Investors in mortgage-backed securities relied on third-party servicers
to collect monthly payments, transmit those payments to various investor classes, and mitigate losses on nonperforming mortgages.
The separation of mortgage ownership and servicing gave rise
to a number of incentive conflicts between loan investors and their
servicers, which made problem mortgages more difficult to address.
These relationships are generally governed by "pooling and servicing
agreements" (PSAs) that specify permissible actions servicers may take
in dealing with delinquent loans. Although the overriding PSA principle
is maximization of the value of the loan pool, some litigation was
necessary to clarify this principle. Even now that the principle has
been established, it can be interpreted in several different ways, particularly for mortgage pools with multiple investor classes or
tranches. In particular, junior investors that are second in line
(or lower) to receive flows generated by mortgage pools have an
incentive to legally challenge modification actions that curtail
overall cash flows. The resulting

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internecine "tranche warfare" discourages servicer actions. Indeed, some observers have argued that servicers tailor their loss mitigation
practices to minimize the risk of litigation by their investors. Because
loan modification is an expensive and uncertain undertaking, servicers
may have an incentive to pursue foreclosures as the least legally
contentious option. Indeed, recent research found evidence of
considerably lower likelihood of modifications for privately securitized mortgages than for portfolio-held loans where no conflicts of interest
are present (Piskorski, Seru, and Vig 2010; Agarwal et
al. 2011).
Moreover, because servicer compensation is based on the unpaid principal balance of performing loans, their incentives are skewed
toward modification practices that favor reductions in interest rates
and adding unpaid loan balances (or arrears) to the principal, even when
that is not the most effective approach to ensuring long-term
performance of the loan. These incentive conflicts, coupled with the
absence of established legal precedent, effectively limited early
modification efforts on securitized mortgages to three alternatives:
adding arrears to principal and either lowering the interest rate or
freezing it on adjustable-rate mortgages (Agarwal et al. 2011).
The unveiling of the Home Affordable Modification Program in
early 2009 substantially changed the playing field for loan
modifications. By establishing a standardized approach to modifying
mortgage contracts that explicitly maximized the return to investors
as a group, the program reduced the exposure of servicers performing
such modifications to investor lawsuits. The HAMP standards have served
as a catalyst for spurring rapid growth in mortgage modification efforts across the industry. As servicers built up their distressed loan infrastructure to accommodate HAMP, they also switched their own
modification focus to more aggressive methods that emphasize loan affordability.


Both the complexity of the existing challenges in the housing
market and the importance to the broader economy of resolving these
challenges call for a robust and multifaceted menu of policy actions.
Over the past three years, the Administration's housing policy has
continued to expand to fit the circumstances, building on the experience
of the early responses to the crisis. The Administration is pursuing additional innovative approaches designed to help households refinance
their mortgages and maintain access to credit, to avoid unnecessary and
costly foreclosures, to stabilize housing prices, and to help
communities rebuild after experiencing a wave of foreclosures and
erosion in property values.

120 | Chapter 4

Building on the Experience of Existing Programs

A number of program modifications are focused on counteracting
the corrosive effects of negative equity. These modifications also seek
to overcome a set of institutional hurdles that have thus far limited
the effectiveness of certain policy actions. In particular, the
Administration worked with the Federal Housing Finance Agency and
private market participants to improve HARP-the existing refinancing
program for borrowers with insufficient or negative equity in their
homes whose mortgages are guaranteed by Fannie Mae or Freddie Mac.
The revised program guidelines announced in November 2011 expand the
pool of eligible borrowers by removing limits on loan-to-value ratios
and extending the program deadline until December 2013. The program also lowers refinancing costs by reducing unnecessary pricing overlays and negotiating favorable pricing on some of the major closing cost items,
such as title insurance. The revised HARP also addresses some of the
difficult institutional hurdles, such as coordination problems with
second-lien holders and mortgage insurers. The changes also lower some
of the representation and warranty requirements for existing loan
servicers, thereby encouraging greater lender participation. In a bid
to further increase use of HARP, the revised program allows servicers to solicit some potentially eligible borrowers directly. Furthermore, major lenders have committed to dedicate additional origination capacity and resources to refinancing HARP borrowers.
Whereas changes in HARP were aimed at dulling the adverse effects
of negative equity on the ability of currently performing borrowers to refinance their loans, other HAMP initiatives tackled the issues posed
by negative equity in modifying loans of delinquent borrowers. In
particular, the Principal Reduction Alternative (PRA), announced in
October 2010, augments the original HAMP focus on affordability with elimination of a portion of the mortgage balance. The PRA builds on the insight that high levels of negative equity contribute to mortgage
default over and above the effects of loan affordability. Consequently, modifications of delinquent loans with high loan-to-value (LTV) ratios
may be more effective if they include a principal reduction component.
The PRA requires servicers of non-GSE loans to evaluate the benefit of principal reduction for loans that exceed the appraised value of the
house by 15 percent or more (that is, have LTV ratios above 115 percent)
in making their HAMP determinations. To encourage servicers to use the
PRA, HAMP provides monetary incentives for investors to write down
principal. At the same time, the PRA seeks to lessen the risk of moral
hazard by implementing principal write-down in three annual
installments and making it conditional on continuous performance of

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modified mortgage. Under this earned principal reduction structure, a
borrower has a strong incentive to remain current, which enhances the
net present value of the PRA modifications to investors. To further
encourage investors to evaluate the use of principal reduction in
modifying problem loans, the Treasury has recently announced a tripling
of the PRA monetary incentives. The Treasury also offered to extend PRA incentives to Fannie Mae- and Freddie Mac-insured loans.
The pace of PRA modifications has picked up appreciably in the
past few months, with more than one in four HAMP modifications receiving principal reductions. According to the latest Treasury report, more than 36,000 permanent modifications that include principal reduction had been implemented by the end of November 2011 (Department of the Treasury
2011). The median PRA loan had an LTV ratio of 158 percent before
modification and a target ratio after modification of 115 percent. The
median amount of principal forgiveness for active permanent PRA
modifications was about $66,000. Because servicers are not required
to offer principal reduction and usually may do so only when permitted
by the loan investor, the growing use of the program suggests increasing acceptance of principal reduction as an effective loss mitigation tool
by private investors.
Similar acceptance is echoed in servicer actions on private,
non-HAMP, modifications. Several servicers have shifted their focus to principal reduction for deeply underwater delinquent loans held in securitization trusts. These reductions are typically earned over time
to encourage borrowers to maintain loan performance. Principal reductions
are also often coupled with a shared appreciation component that
exchanges forgiven principal for an equity stake in the property. If the market value of the house in a future sale or refinancing exceeds its
value at the time of principal reduction, the borrower shares a part of
the appreciation with the lender. Much like the earned principal
reduction, shared appreciation effectively raises the borrower's costs
of defaulting to qualify for principal forgiveness.
Another HAMP-related initiative recently announced by the
Department of the Treasury expands the reach of the program by
broadening eligibility. One of the reasons many borrowers have not been
able to take advantage of the program is that eligibility was tied to
first-lien mortgages. Some borrowers with high medical debts, for
example, but relatively average mortgage burdens, did not previously
qualify for the program. By expanding eligibility, the changes aim to
extend loan modifications to such borrowers and lower the number of preventable foreclosures.
The Administration has also expanded housing assistance for
unemployed or underemployed homeowners. To help out-of-work homeowners
avoid foreclosure, these programs generally provide for a period of

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forbearance of all or part of the monthly mortgage payment. In July
of 2011, as the length of unemployment spells continued to exceed
forbearance periods for many of the unemployed homeowners, the FHA
and the Treasury announced the extension of forbearance to 12 months.
This change applies to mortgage servicers that participate in the HAMP's unemployment initiative program (HAMP UP), as well as to the FHA Special Forbearance program. Following the Administration's lead, two major
lenders and the GSEs have recently announced their commitment to
provide up to 12 months of mortgage payment forbearance to unemployed borrowers.
Mortgage payment assistance for unemployed or underemployed
homeowners has become a prominent feature of state level programs
developed under the Hardest Hit Fund (HHF). The President announced the establishment of the Fund in February 2010 to provide targeted aid to
families in states that have been hit hard by the economic and housing
market downturn. HHF currently provides assistance to homeowners in 18
states and the District of Columbia. The specific programs are designed
by state housing finance agencies and take into account local market conditions. In addition to helping unemployed borrowers, HHF programs
commonly include efforts to fund innovative approaches to modification
of delinquent mortgages and to allow homeowners to transition into more affordable places of residence.
Furthermore, in June of 2011 HUD launched the Emergency
Homeowners Loan Program (EHLP) which provided $1 billion in
interest-free loans to help keep borrowers in non-HHF states who are unemployed, or who suffer from a severe medical condition, from
losing their homes. The EHLP is available to borrowers with a long
track record of staying current on their mortgages but who find their
ability to continue doing so compromised by job loss or illness. EHLP
loans are secured by a junior lien note on the homeowner's principal residence, and the balance on these loans is forgiven in 20 percent
increments for each year the borrower remains current on regular
mortgage payments.
The Administration's Project Rebuild, introduced as part of
the American Jobs Act in September 2011, is another example of
building on the experience of existing housing programs. While the
revised HARP and the HAMP PRA focus on negative equity, Project
Rebuild addresses the damaging effects of foreclosed or abandoned
homes on neighborhood property values, economic prospects, and
social fabric. Project Rebuild seeks to integrate and expand
strategies proven successful under the Neighborhood Stabilization
Program to deal with vacant and foreclosed properties. In
particular, it explicitly allows federal funding to support for-profit development subject to HUD oversight. It also extends rehabilitation
efforts to

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commercial as well as residential properties. Project Rebuild further
calls for expanding support for land banks that work at the local level
to acquire, hold, and redevelop distressed properties. Federal funds
granted under the project would provide land banks with capital
infusions that can be leveraged with private-sector investments to
finance long-term redevelopment strategies.

New Levers in Housing Policy

Refinancing. The Administration has called on Congress to pass legislation that will enable more homeowners to refinance their
mortgages at today's historically low interest rates. First, the HARP
program is available only to homeowners whose loans are owned or
guaranteed by the GSEs. This restriction has left some borrowers
unable to refinance their loans only because their mortgages were kept
on the originating bank's books or were securitized in the private, as
opposed to the GSE, market-events largely outside of a borrower's
control. To remove this arbitrary distinction, the Administration
proposes that the FHA be authorized to offer streamlined refinancing
to non-GSE borrowers with standard mortgage contracts. To limit
risks to the taxpayers, the proposal emulates HARP in requiring
eligible borrowers to have remained current on their mortgages
and to meet certain underwriting standards. Another risk-management
component of the proposal includes capping the loan-to-value ratio of
eligible loans.
Second, while enhancements to HARP announced in November of
2011 will increase the reach of the program, more can be done to
reduce the barriers to refinancing of GSE-backed loans. Such steps
would include harmonizing underwriting requirements for mortgages
with LTV ratios below and above 80 percent; further reducing loan
fees because GSEs do not acquire any new credit risk by refinancing
these loans; fully aligning the treatment of representations and
warranties for refinancing with the existing or new mortgage
servicers; and removing remaining differences in HARP requirements
that still exist between Fannie Mae and Freddie Mac. These changes are
aimed at streamlining the operational requirements of the HARP program
and making it more accessible to a greater number of borrowers. By
leveling the playing field between existing and new servicers, the
proposed changes also seek to harness competitive forces to bring
more interest savings to borrowers.
Third, the Administration's proposal helps address the
problem of negative equity by providing a pathway for responsible
homeowners who refinance their mortgages to rebuild their equity
more quickly. Under this option, home owners would refinance into
a shorter-maturity (20-year, for example) mortgage and commit to
deploying the savings from refinancing

124 |  Chapter 4

to rebuilding equity in their homes. As an example, consider a
borrower who has a 6.5 percent mortgage originated in 2006 with an
outstanding balance of $200,000, whose house is worth $160,000
(a loan-to-value ratio of 125). This borrower could lower the monthly
payment by $166 by refinancing into a 20-year mortgage at 3.75
percent. Should the borrower choose to keep their mortgage payment
at its original level and direct the $166 in savings to principal
reduction, the outstanding mortgage balance would decline to $152,000
in five years. Under the proposal, underwater borrowers would have
the choice of pursuing this pathway to rebuild their home equity.
To assist borrowers who make this choice, the proposal directs the
GSEs and the FHA to cover the closing costs of their refinanced loans.
Servicing standards. The experience of the past few years
showed that the Nation is not well served by the patchwork of rules
that govern the mortgage servicing system. To improve accountability
and align incentives in the mortgage servicing industry, the
Administration recently released a unified framework of servicing
standards-the Homeowner Bill of Rights--that is designed to better
serve borrowers, investors, and the overall housing market.
The Administration will work closely with the Consumer Financial
Protection Bureau (CFPB) and other independent regulators, Congress,
and other stakeholders to create a more robust and comprehensive set
of rules driven by a set of core principles outlined in the
framework. These principles include full disclosure of all fees
provided in understandable language upfront, with any changes
disclosed before they go into effect. The framework also requires
servicers to implement standards and practices that minimize
conflicts of interest, such as those that exist between multiple
investor classes and those that arise when the servicer simultaneously
owns a secondary lien on the property. To make loss mitigation actions
more timely and effective, servicers are required to contact homeowners
who have demonstrated hardship or fallen delinquent, and provide them
with a comprehensive set of options to avoid foreclosure. Servicers
must further allow homeowners the right to appeal denials for mortgage modification to an independent third party and provide homeowners who
find themselves in economic distress with access to a customer service employee with a complete record of previous communications with that homeowner. To minimize inappropriate foreclosure actions, servicers may schedule a foreclosure sale only after they have certified in writing
that all loss mitigation alternatives have been considered. To ensure compliance, servicers must maintain strong controls over servicing and
loss mitigation operations and subject these controls to periodic
independent audits. The Homeowner Bill of Rights is meant to provide
an enforceable set of rules, not just guidance, for the servicing

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Conversion of Repossessed Properties into Rental Units. An
orderly, fair process for disposition of foreclosed properties remains
a key objective of housing policy. Given the ongoing reduction in rates
of homeowner-ship, many foreclosed properties will have to be converted
to rental units, a process that typically involves rehabilitation. The
demand for this type of housing stock will come mainly from private
investors whose activity to date has been hampered by execution problems
in putting together property portfolios through a series of small-scale acquisitions. Tight credit conditions for financing investment
properties have further limited the ability of private investors to
fill the gap in demand.
To counteract these problems, the FHFA, with the Departments of Treasury and Housing and Urban Development, initiated a process to
manage the sale of REO properties held by Fannie Mae, Freddie Mac and
the FHA. The goal of this effort is to allow private investors to bid
on acquiring pools of REO properties in exchange for a commitment to rehabilitate and manage the properties as rental units. Bulk purchases
will make it easier for investors to achieve economies of scale as they implement their individual business strategies. Qualified bidders must demonstrate evidence of property management experience and adequate capital resources, as well as agree to abide by property usage restrictions. For instance, antiflipping provisions establish minimum time periods that an investor must hold the property before seeking to sell it, and minimum reinvestment requirements impose certain quality standards for rented properties.
In many ways, the REO-to-rental conversion program seeks to
build on the best practices established by successful policy
interventions during the crisis. The program focuses on leveraging the expertise and financial resources of private investors, while
preserving value for the taxpayers. It looks to avoid rigid top-down solutions, allowing for customization at the local level. And it makes
use of the unique position of the GSEs and FHA as owners of large
nationwide inventories of distressed properties to provide a
large-scale, transparent, and predictable mechanism for converting these properties to better suit local housing demands. Furthermore, the
process is intended to help the industry develop a viable framework
for acquiring and managing large-scale scattered-site rental portfolios. Similar to the HAMP experience, this framework may well help establish industry standards.

Developments in the housing market played a central role in the financial crisis and the ensuing recession, and they continue to
present a headwind for the economic recovery. Although housing markets
are stabilizing

126 |   Chapter 4

in many regions, the healing process will inevitably take time. This is
a reflection of both the magnitude of the recent housing price collapse
and the many institutional obstacles on the path to a new equilibrium.
Getting to the end of this path will require unwinding accumulated
inventories of foreclosed homes, whether by finding new owners or by converting them to rental units. It will require enabling more
homeowners to refinance their mortgages at today's low interest rates.
It will require resolving multiple conflicts of interest in the
modification of delinquent loans and providing meaningful assistance to unemployed homeowners as they search for new jobs that would allow them
to remain in their homes. It will require restoring access to credit
for responsible borrowers and repairing household balance sheets hard
hit by erosion of home equity. And it will require working out legal uncertainties and fixing up mortgage finance markets.
Instead of waiting for these processes to play themselves out
slowly and painfully, the Administration has embarked on a series of multifaceted and fiscally responsible actions in partnership with
private market participants and housing regulators to proactively
repair the housing market and ease the transition to a new and stable equilibrium. The new policy initiatives seek to enable refinancing,
to unlock access to credit for responsible underwater homeowners, to reallocate foreclosed properties to the rental market, to prevent
unnecessary foreclosures for borrowers struggling with temporary loss of income, to implement sustainable modifications of delinquent loans,
and to repair the frayed infrastructure of mortgage servicing and
mortgage finance.

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