The Housing Abyss

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Owners of mortgage-backed securities are several steps removed from what's happening in the housing market. The securities' designers never envisioned having to cope with massive defaults, says Vincent Barberio, a managing director in the residential mortgage-backed securities group of Fitch Ratings, based in New York. For example, to preserve favorable tax treatment, most securitization deals contractually limit the number of loans that can be modified to anywhere from 2% to 7%—an unrealistically low level given that in some pools a third or more of the loans are delinquent. Insurers of mortgage-backed securities, too, can hold up restructurings that will trigger claims against them. And the terms of some servicing agreements turn out to give loan servicers a financial incentive to let loans go into foreclosure rather than be restructured, says Kathleen C. Engel, an associate professor at Cleveland-Marshall College of Law.

Industry players are well aware of the multiple problems but haven't been able to craft a compromise. In April the Treasury hosted an all-day meeting with the largest lenders and servicers, but it produced no decisive action. On June 17 the newly formed Coalition for Mortgage Industry Solutions held a loftily titled Leadership Summit in Washington but came away with little to show for it—leading some participants to speculate that the government will cram a solution down the industry's throat. Mark S. Zuckerberg, a consumer-bankruptcy attorney in Indiana who attended the summit, said: "I met some very powerful people, but the meeting itself was a complete waste of the day."

What more might government do? The Federal Reserve has already intervened heavily, of course. In addition to slashing short-term interest rates, it has extended more than $150 billion in secured loans to banks. Anything more from the Fed would leave it open to charges that it was subsidizing the banks and raising the risk of inflation.

Washington, meanwhile, has its own issues. The Treasury Dept. has made little headway in jawboning lenders into speeding up loan workouts. Reasonably enough, President George W. Bush and many congressmen on both sides of the aisle oppose using taxpayer dollars to bail borrowers and lenders out of dumb mistakes. There's also concern about overly favoring the handful of big states where the problems are worst, including Arizona, California, Florida, Michigan, Nevada, and Ohio.

The Democrats' centerpiece legislation, bills sponsored by Representative Barney Frank (D-Mass.) and Senator Chris Dodd (D-Conn.), is designed to keep creditworthy borrowers in their homes with new, more affordable loans insured by the Federal Housing Administration. By preventing some forced sales, it could help neighborhoods plagued by foreclosures. But to keep the cost down, Congress was forced to make the terms so stringent for lenders and borrowers that only a fraction of people needing help—perhaps 500,000 homeowners, by a Congressional Budget Office estimate—would likely get the loans. (The bill also permanently raises the size of mortgages that Fannie Mae and Freddie Mac can buy and has an $8,000 tax credit for first-time home buyers to stimulate sales.) "It has taken time for the pragmatists to seize the initiative over the idealists," says Jaret Seiberg, a Washington (D.C.)-based financial service analyst at Stanford Group.

If the housing market continues to weaken, action in Washington could heat up next January, when a new President and Congress take office. The next President, whether Democrat or Republican, will have more flexibility to be bold because he will be starting with a clean slate, although Barack Obama has taken a far more interventionist stance than has John McCain. One proposal Obama backs is to amend the federal bankruptcy code to let judges force mortgage lenders to take a loss on their loans as part of a Chapter 13 settlement. Or Congress could expand the Frank-Dodd plan to cover more people.

But expect strong pushback on that last idea from fiscal conservatives. The Wall Street Journal's editorial page observed on June 21 that the FHA lost $4.6 billion last year, making it a less-than-obvious candidate to guarantee billions in troubled loans. An even bigger stretch: The FDIC's Bair has begun arguing that the federal government may ultimately have to provide low-cost loans directly to borrowers to help them pay down their unaffordable mortgages.

At this stage, none of those options has much of a shot at getting enacted because the pain of the housing bust hasn't been severe enough to overcome the logical objections. But if the bust worsens—and that downward spiral is increasingly likely—lots of unappetizing ideas might suddenly seem perfectly reasonable.

With Jane Sasseen in Washington, Ben Steverman and Prashant Gopal in New York, and Christopher Palmeri in Los Angeles