The rising tide of real real estate prices in the 1997-2006 period lifted the boats of both the home buyers and mortgage issuers. The home buyers were enticed by the prospect of ever rising values for their investments. Many of them saw real estate as a remunerative investment, to be rolled over within a few years after the prices rise. The rapidly emerging market in mortgage backed securities (MBS) meant that the mortgage lenders could off-load their loans and move on to making ever more loans.
The plain vanilla fixed rate mortgages were replaced by Adjustable Rate Mortgages (ARMs), which involved re-negotiations after a few years. There were "interest only" loans which insisted on just interest repayments for the first few years, and "teaser rate" loans which had low up-front rates. Many of these loans were issued even without any buyer equity, on the full cost of the house. All these suited the incentives driving buyers with short time horizons, looking for handsome investment returns.
Now, with re-negotiations round the corner in many of these ARMs, the owners are left holding assets whose values are smaller than the loan amount outstanding. The re-negotiated ARMs will be at much higher rates and involve even doubling of the instalments. The mortgage issuers too have tightened their lending standards and are insisting on the buyers putting up one-fourth to one-fifth of the cost as owner-equity. Faced with all this, since these mortgage loans are non-recourse ones with liability limited to only the house, many mortgage holders find it meaningless to continue their repayments and are shifting to rented accomodations.
As the home prices fall, the gap between the housing collateral and the loan will widen, forcing up interest rates and instalments, thereby increasing the prospects of more foreclosures. If the Case Shiller index is any indicator, home prices still have a long distance to fall before it attains its pre-1997 values.
The bailout plan by recapitalizing the banks and providing short term liquidity, only addresses the symptom and leaves out the fundamental cause. If the home prices continue to fall, more mortgage holders will walk out and foreclosures will mount, and no amount of recapitalization will suffice. It will be $700 bn of good money down the drain. It seems clear that any sustainable solution should involve addressing the problem faced by the mortgage holders, and not just the mortgage financiers.
Update 1
Martin Feldstein agrees with my arguement. He feels that as more homeowners walk out and foreclosures mount, the downward spiral will only get accentuated.
Update 2
NYT has this article on what Glenn Hubbard calls the "leelphant in the room" - falling home prices that leave owners with "impaired mortgages". It describes a few homeowner bailout plans and favors one proposal by Daniel Alpert of Westwood capital. Under the plan, a law would be passed to encourage homeowners with impaired mortgages to forfeit the deed to their lenders but allows them to stay in the homes for five years, paying prevailing market rent. Under the law the lender would be forced to accept the deed, and the rent. After five years, the homeowner-turned-renter would have the right to buy the home back, at fair market value, from the lender. By this, the home owner loses his equity ownership, albeit temporarily, and the lender takes a loss by way of lower rents.
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