REPORT: Time to Quarantine the Foreclosure Epidemic

In 1902, faced with an outbreak of smallpox, the City of Cambridge,
Massachusetts, adopted a mandatory vaccination law. Challenged by a Mr.
Henning Jacobson as an unconstitutional infringement upon his
liberties, this intrusion on individual rights was nonetheless upheld
by the U.S. Supreme Court. Even more intrusive quarantines have been
found lawful as a means to stop the spread of plague, influenza, and
other cascading threats to the public health and well-being.

Today, our country faces a different kind of epidemic. With house
prices having plunged again in November at possibly an all-time record
rapid drop, roughly 12 million borrowers now owe more than their homes
are worth--double the number from a year earlier and expected to rise
to nearly 15 million this year--while another 8.1 million foreclosures
are expected over the next four years. Over 1 in 10 Americans are in
mortgage default. It is time to re-evaluate how we think of the
situation.

By any reasonable measure, we confront a spreading foreclosure
epidemic that is eating away at the core of the nation's economic
health. However well-intentioned, private and governmental efforts to
date have not contained the damage. In the early stages of a public
health crisis, voluntary treatment of the ill also fails to stop the
spread of disease. What makes certain epidemics so devastating is that
normal delivery systems for patient treatment are overwhelmed by the
sheer number of cases all happening virtually at once.

Moreover, epidemics often infect health workers themselves, further
weakening the normal recovery systems. And when rising illness rates
and falling resources combine, the health care system is further left
unable to help other ill patients, who themselves then get sicker than
they might in normal times.

Looking at the current foreclosure crisis as an epidemic, the
parallels emerge. At a normal rate of borrower defaults, the financial
system can "clear," in industry parlance, bad assets such as troubled
home mortgages through workouts and occasional foreclosures. Today,
however, it is abundantly clear that multiple foreclosures in many
communities are infecting neighboring homes with rapid value
dissipation. If left unchecked, this will lead to further community
malaise due to lost tax revenues, increased crime and fire prevention,
and a general draining of public resources.

Similarly, some players in the financial system who could have
addressed scattered defaults themselves are "sickened" when
foreclosures soar. Over 100 mortgage companies that originated many of
the subprime mortgages are now out of business, and servicers who
remain suffer capacity shortages to deal effectively with all the
borrowers in need. Finally, homeowners with prime mortgages or good
incomes who might have not gone into default in normal times now see
themselves also "upside down," owing more on their home than it is
worth in the market, leading to home equity lines being called, or
lacking home equity to deal with what would otherwise be normal
borrowing for unexpected setbacks, college tuitions, and the like.

The upshot: Entire communities have become economic casualties of
the main epidemic, and this plague continues spreading. Consequently,
it is time we consider stronger measures--the economic equivalents of a
quarantine. What can be done? Several extraordinary actions for
extraordinary times need to be given greater urgency.

Exploding REMICS

Over nine months ago, the Center for American Progress put forward a proposal
by Michael Barr and James Feldman to modify the Real Estate Mortgage
Investment Conduit, or REMIC rules to open a path for the servicers of
loans to accelerate modifications and prevent unnecessary foreclosures.
In 2009, we need to go a step further than simply implementing these
needed changes.

REMIC status offers an enormous tax benefit to investors in the
residential mortgage trusts that hold millions of mortgages. Many
individual mortgages held in these pools are heading toward
foreclosure. Recognizing that REMIC status is a special privilege, it
is time to revoke REMIC status for any residential home mortgage
loan-holding entity that forecloses on more than a certain percentage
of all of its mortgages.

This step, alongside other REMIC and accounting changes outlined in
the CAP proposal and elsewhere, would free up the ability of mortgage
service companies that collect individual mortgage payments and
distribute them to their investors to modify troubled home mortgage
loans, or sell them off at a discount. The potential revocation of
REMIC status would dramatically incentivize loan servicers to halt
foreclosures and restructure loans to affordable levels, or sell them
to those willing to do so Getting defaulted mortgages out of the hands
of mortgage servicers so that systematic modifications based on
sustainable principal and interest payments is perhaps the only
broad-based approach likely to turn around the current price plunge.
Congress already authorized the Treasury Department through its
Troubled Assets Relief Program to buy up troubled mortgages, and
previously funded the Federal Housing Administration as a source of
refinancing. But to date, servicers have not been sellers. The economy
cannot afford any longer to wait for them to decide to seek the
economic equivalent of medical help. We need to put mortgages into
temporary foreclosure quarantine.

National foreclosure moratorium

In the 1930s, state after state adopted moratoriums on foreclosures, dramatic action upheld by
the U.S. Supreme Court. While hardly the best course of action in
normal times, barring foreclosures to stem the downward spiral is a
necessary part of a quarantine approach.

Even with the REMIC law changes, the sale of mortgages into the
control of parties motivated to make lasting loan modifications will
take some time under the best of circumstances. Congress could begin
with a six-month moratorium, a reasonable time for transfers to occur
and extendable if the situation has not improved. But given the
national economic consequences of the current foreclosure wildfire, a
federal moratorium approach is justified both to stop further price
declines and to make more aggressive loan modifications a better
alternative.

Even the bankruptcy playing field

As an adjunct to these other measures, granting borrowers in
bankruptcy proceedings the same mortgage modification rights enjoyed by
commercial real estate owners and even second-home owners is long overdue.
Currently, judges have no authority to force a lender to restructure a
homeowner's mortgage on a primary residence to a level that reflects
the current home value. This puts all the burden of the loss--which
clearly under today's circumstances is a loss in value beyond what
either party could have anticipated--only on the consumer.

Giving homeowners the same bankruptcy options as enjoyed by Donald
Trump is a fairer way to spread the burden of the current downturn and
gives lenders a needed incentive to reach a more realistic modification
to avoid the bankruptcy courts to begin with. Even those in the
financial services sector that have long opposed such a move,
among them Citigroup Inc., the National Association of Home Builders,
and the American Bankers Association, recognize this course of action
may now be needed. Indeed, serious studies have concluded that "mortgage markets are indifferent to bankruptcy modification risk."

Stronger government interventions in the market such as these will
inevitably raise objections. Some will argue that any change in the
current status quo will amount to a "taking" of private property. The
power to take such actions, however, was upheld in the Depression era,
and in other cases of economic necessity in the past. Indeed, forcing
the sale of mortgages outright by invoking eminent domain using
existing statutory powers was recently advocated by Harvard Law School Professor Howell Jackson.

In the end, the takings issue boils down, in the situation of a
frozen malfunctioning market, of whether the government is paying
owners just compensation. The financial complexity and split ownership
of mortgage-backed securities in which most mortgages are now bundled,
combined with buyers sitting on the sidelines while prices plunge,
makes it almost impossible for the marketplace to function properly.
Market dysfunction requires government action even though this may be
contentious, and our legal system has well-established mechanisms for
looking back and valuing property after it is taken.

Others will assert that some of the proposed actions will distort
the market, but that talismanic argument is belied by recent financial
history. If swifter action by regulatory authorities had been taken
initially to prevent the widespread selling of poor mortgage products,
and then to recognize the full scope of the home mortgage crisis and
prevent foreclosures, then our government would not have had to
intervene in the economy in a manner so forceful that it could hardly
have been imagined just 12 months ago. Given widespread current market
failure, bolder actions are necessary in the short term precisely
because we need the government to help restart a normally functioning
market balance between sellers and buyers of homes along with a stable
home mortgage finance system.

Finally, a common argument against intervention is the refrain that
since 90 percent of borrowers are still paying their mortgages, any
action to help defaulted borrowers avoid foreclosures will somehow
induce more borrowers to go into default. Yet the vast majority of the
90 percent who have not yet defaulted will not be eligible for any
modification as they still have reasonable equity cushions above their
mortgage balance, and/or their loan payments relative to income are
below the modification guidelines.

It is possible that at the margin, some borrowers looking ahead to a
time when they expect to hit trouble may default sooner. But defaulting
still comes at a great cost to the homeowner--a bad credit rating, very
time-consuming workout process, and heavy financial scrutiny. And of
course it is not as if we don't do these interventions, then no more
borrowers will go into default. The cost of staying on the current
course is almost certainly millions more foreclosures, and a dramatic
further drop in values for the rest of us.

As with a health epidemic, there is no way to perfectly match those
who need treatment with the remedies necessary under extreme
circumstances. Some who may get pulled into the quarantine who would
have recovered without it. But if conventional remedies were working,
then things would not have reached today's epidemic proportions.