The Risk from Underwater Homeowners

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Lowering the amount that people owe on their homes would obviously help the homeowners. What's surprising is that it might even benefit the people who bought their loans, bundled into mortgage-backed securities. How could that be? Because the values of those securities have already plunged—in some cases to as little as 25¢ per dollar of face value—in the expectation of massive foreclosures. If big writedowns managed to keep more people in their homes, it could actually enhance the value of those mortgage-backed securities.

Lawsuits Are an Obstacle

There is one potential obstacle to big principal adjustments that the Obama plan doesn't address: litigation over writedowns by investors who bought stakes in the vast number of mortgages that have been securitized. A minority of the "pooling and servicing" agreements governing securitized loans explicitly restrict modifications. Even in cases where modifications aren't banned, servicers say they worry about getting sued anyway for abrogating unwritten responsibilities to investors.

Indeed, on Dec. 1, William Frey, a private investor in mortgage-backed securities, filed a lawsuit in New York State Supreme Court alleging that the proposed modification of some 400,000 home loans originally underwritten by the defunct lender Countrywide Financial is illegal.

Many in the industry expected the Administration's proposal to include a "safe harbor" protecting servicers against lawsuits where loan modifications benefit investors as a whole more than foreclosure would. But while Congress is contemplating such protections, the Obama plan doesn't—and one Democratic Senate aide says Administration officials have been distinctly cool to the idea.

A Missed Opportunity

Is there an argument against massive writedowns of principal for underwater homeowners? Sure: It rewards the person who put no money down, and it does nothing for the next-door neighbor who put 20% or 30% down and still has equity. "I don't think you're going to find any sympathy for that," says Guy Cecala, publisher of Inside Mortgage Finance, an industry newsletter. Trouble is, trying to treat those two neighbors equally could have unintended harmful consequences for the neighborhood if the family that's underwater simply walks away.

Ultimately, strong resistance to principal writedowns in the industry—whether from legal concerns, because banks can't absorb the paper losses, or because it sets a worrisome precedent for other borrowers—means implementing such a program would involve "a major time delay," a senior Administration official says. "If you're going to try to prevent the foreclosures now, you can't go that way."

The Obama Administration missed another opportunity to help underwater homeowners when it limited the assistance it is offering homeowners who are current on their mortgage payments. In a step in the right direction, the Obama plan allows Fannie Mae (FNM) and Freddie Mac (FRE) to finance new, more affordable mortgages even if homeowners owe more than the current standard of 75% to 80% of their home's current value. But for unexplained reasons, there's a cap on eligibility. Fannie and Freddie still won't be allowed to help with refinancings if the loan-to-value ratio exceeds 105% (e.g., the loan is $210,000 and the house is worth $200,000).

Putting a cap on eligibility for refis cuts out many of the people who most need a break and doesn't appear to make any sense from the government's viewpoint either, says Christopher Mayer, a Columbia University economist who has helped devise homeowner-rescue plans. Throwing open eligibility for cheaper loans to anyone who currently has a loan owned or guaranteed by Fannie and Freddie would lower default rates and thus the ultimate cost to the agencies and taxpayers, says Mayer. He adds, "I don't understand why they did this."

Coasts Hit the Worst

Moreover, "private-label" mortgages that lack Fannie or Freddie's backing—particularly in California and the Northeast, where home prices are higher and subprime mortgages more common—aren't eligible for Fannie and Freddie refis at all. "Where the markets have been hardest hit on the coasts, where private mortgages are the biggest, this program won't really help," says a fixed-income portfolio manager for a major mutual-fund management firm.

The senior Administration official said the 105% cap seemed advisable in part because re-default rates tend to rise with high loan-to-value ratios. And the government excluded private-label loans from the refinancing program because it little or no authority to dictate rate changes where government-affiliated entities don't provide guarantees.

Obama's plan is broader and stronger than Hope for Homeowners, the unwieldy, mostly voluntary program passed by Congress last summer. On the other hand, that's not saying a lot. Hope for Homeowners has refinanced a microscopic 25 mortgage loans so far. Even a thousandfold improvement over that would still constitute failure for the Obama Administration. That's why this plan may require some changes in the months ahead.

Coy is BusinessWeek's Economics editor. Francis is a writer in BusinessWeek's Washington bureau.