During the month of August, financial markets around the world were battered by the onslaught of a deepening crisis in the U.S. secondary mortgage market. The troubles at Countrywide Financial Corporation, the largest mortgage lender in the country, intensified concerns over the health of the larger U.S. economy. It is not yet clear whether the current troubles will lead to a serious financial crisis or if they are simply the first manifestations of an expected market correction. In either scenario, however, there are potentially adverse consequences for New York City and its communities that the housing industry must address.
Our communities now face three distinct yet very connected challenges that can be imagined as a series of concentric circles. First, the number of mortgage defaults is increasing rapidly, threatening individuals and families, as well as the housing stock they occupy. Second, the largest increases in foreclosures are occurring in neighborhoods that have seen substantial public investment over the last two decades where the effects will be particularly damaging.And finally, the constriction of credit jeopardizes new investment into communities where acute housing and community development needs continue to exist.
Because Countrywide underwrites over $40 billion in loans each month, the inability to raise new funds caused immediate concern over the company’s financial health. Its stock price dropped 23 percent between August 14th and 16th and it was forced to exhaust an $11.5 billion emergency line of credit. On August 17th, the Federal Reserve cut the primary discount-window rate by 50 basis points in order to add liquidity to the market. Then on August 22nd, Bank of America Corporation invested $2 billion of cash equity into Countrywide, reassuring financial markets that an imminent collapse was unlikely. More recently the company announced plans to lay off up to 20,000 employees, or twenty percent of its workforce.
There were three factors that contributed to the collapse of the secondary mortgage market and led to the present liquidity crisis. First, a proliferation of exotic mortgage products began to appear on the market in 2001. Second, a dramatic run up in home prices came to an end with some markets even experiencing declining property values. Both factors contributed to the third problem: a rising number of delinquencies and defaults.
The most notable exotic mortgage product to be introduced was the Option Adjustable Rate Mortgage (ARM) that gave consumers a choice of paying interest only, interest plus a portion of the principle, or the fully amortized amount each month. While such ARMs were highly profitable for lenders, they were often marketed to consumers with little understanding of their terms. Generally, they offered a very low initial interest rate which would reset after a period of two years. Mortgage brokers often received higher commissions for the inclusion of prepayment penalty terms. In return, consumers were given more favorable rates upon expiry of the first term of their loans.
With strong federal policies encouraging homeownership and easy access to credit, housing prices rose dramatically over the past six years and equity gains made it possible for buyers to refinance many of these loans after their initial terms. Loans made in 2005 and 2006, however, are just now coming to the end of their first two-year “teaser” terms. With housing prices remaining flat or in some cases beginning to decline, any expectation consumers had about refinancing such loans to a lower monthly payment are quickly evaporating. Plus many of the financing products that once readily supplied easy credit are no longer available.
This combination has led to a sharply increasing number of foreclosures nationwide. The subprime delinquency rates for the quarter ending in June stood at 14.82 percent, just below the cyclical highs of 14.96 percent in 2002 [see Figure 1]. Yet because the subprime market has grown so much in the previous five years, the current delinquency rate is equivalent to a 78 percent rate in 2002.2 And though the effects have been somewhat late coming in New York where Wall Street money and foreign buyers have kept prices strong, investors in the secondary market products are not able to discriminate as to geographic location or housing market. Also, it is generally not possible to restructure the terms of bad loans as investors are spread out around the world.
What Can Be Done?
A significant portion of mortgage defaults, even in New York, are occurring on one- and two-family homes. For policy makers, dealing with single family homes is often more challenging than assisting larger multifamily buildings. Policy prescriptions can take two forms: those that seek to assist owners before they are forced to vacate their homes and those that target buildings and maintenance in selected neighborhoods. The line between those consumers that were unwittingly taken advantage of and those that simply over leveraged themselves is a fine one. It remains an open question about whether or not public policy should seek to assist consumers that simply made irresponsible financial decisions.
One of the biggest fears when the number of foreclosures in a given neighborhood begins to increase is that properties will not be maintained and that a critical mass of such properties will depress values throughout a given area. One way toprevent this would be for the City to intervene prior to the foreclosure auction. In effect this would create a new version of in rem. It is not clear, however, whether the City could effectively deal with a large stock of properties in a down or declining market.
One way to keep owners in place as tenants until they are able to repurchase their properties would be to construct a leaseback program whereby the City or a non-profit organization functions as interim owner. The City would need a large pool of funds for property acquisition if it were to adopt such a policy. In the United Kingdom, shared ownership is a common option for lower income households. In the current scenario, a foreclosed home could be purchased jointly by a non-profit and the existing owner. Such an option, however, would still require large amounts of capital.
Both the State of New York and the federal government have indicated a willingness to assist some homeowners. On September 4th, the State of New York Mortgage Agency introduced the Keep the Dream Mortgage Refinance Program. $100 million will be available to prevent distressed homeowners with interest-only and non-conventional loans from defaulting. President Bush recently announced FHASecure, a federal program that will assist about 80,000 borrowers nationwide to refinance delinquent loans with FHA insurance premiums. Such programs, when well targeted, can be helpful but will only be able to assist a narrow segment of the population.
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1. NYC Department of Finance, NYC Business Income Tax Collection Update, FY 2006 2nd Quarter.
2. High Frequency Economics, Daily Notes on the United States. September 7, 2007. Also see Figure 1, data from Mortgage Bankers Association.
(This brief has been written by Jeffrey Otto, adapted from a discussion held at CHPC on August 27, 2007. The following persons were in attendance: Sandra Acosta, John Daviglio, Tanya Dempsey, Henry Lanier, Dan Levitan, Marvin Markus, Lucille McEwan, Jeffrey Otto, Jerilyn Perine, Vincent Rizo, Richard Roberts, Brian Siegel, Gordon Shanks, Harold Shultz, Phil Tugendrach, John Warren, and Marian Zucker.)