A Proposal for Reducing Home Loans

To solve the Subprime Mortgage the US government has been pressuring banks to write off "tens of billions" worth of mortgage debt. Yesterday, the NY Times reported (here) that Bank of America (BoA) CEO Brian T. Moynihan was pushing back saying the idea is unworkable and unfair to borrowers who pay their mortgages and, more importantly, to investors who hold the mortgages. It's interesting to compare Mr. Moynihan's "push back" against the government with his strategy (stated in the video above) for increasing returns on BAC stock and the company's role in acquiring Lehman Brothers at the bottom of the financial crisis.

Mr. Moynihan has another problem (in addition to digesting nonperforming acquisitions) which is working off the bubble of nonperforming mortgages on the books of BoA, the nation's biggest mortgage servicer. Terry Laughlin, the BoA executive who handles delinquent or default mortgages says that dealing with underwater borrowers that have negative equity in their homes "is an unsolvable" problem on "... a very slippery slope."

Here's a "theoretical" proposal for dealing with reducing home loans. The crucial issues is to decide how much to write the mortgage down. It would be unfair to write the mortgage down to the level that the borrower can afford to pay since the borrower may be able to afford very, very little. Forcing borrowers to pay the full "bubble" price of the home also seems unfair since those values were unrealistic.

The graphic above shows the dynamic attractor for home prices (the Case-Shiller Composite US index) as a dashed line with the actual home price values displayed as a solid line. Comparing the two lines shows that from 1990 to around 2001, home prices were somewhat below their dynamic attractor. After 2001, the "bubble" is clearly evident. And, during 2010, home prices returned to their long-run dynamic attractor.

My proposal is simply to value home prices, for the purpose of mortgage modification, at the long-run attractor value. Banks and their investors who acquired mortgages after 2001 will loose some money. Maybe next time they will realize that purchasing inflated assets during a housing bubble is a bad idea. Some borrowers will not be able to pay their loans even at 2010 prices. They will have to go through foreclosure or a short sale.

Of course, this is a theoretical idea. When we get down to valuing a specific mortgage, guesses would have to be made about the value of a specific home. To do this an assessor would have to look at the home in light of comparable home sales and the relationship of the local market to the appropriate regional or national composite Case-Shiller index. Models could also be developed for use by the assessor, but ultimately a judgement has to be made as is always the case with home valuations.

THEORY: Housing prices as traced by the Case-Shiller index are best described using a business-as-usual model: P(t) = a + b P(t-1). For whatever reason (good or bad) housing prices are not strongly linked to performance in the US or the World economy. They are also not a random walk. One would think that the US economy model, P(t) = a + b P(t-1) + C E(t-1) where E is the state of the US economy, would provide a better dynamic attractor for housing prices. It might, but for present purposes the BAU model will be just as good and easier to understand.