A Solution to Mortgage Crisis

Some 2.2 million homeowners face foreclosure, thanks to the subprime-mortgage bust. Their losses will drag down the value of nearby homes whose owners are faithfully making monthly payments. That implies worse to come for the institutions—hedge funds, mutual funds, pension funds and banks—that invested in these high-risk loans. Everyone says that something must be done, but what?

Subprime borrowers have modest credit scores and little or no cash for a down payment. They took "exploding" loans, at 7 to 9 percent for the first two or three years, expecting to refinance at lower rates. But the market turned against them. Their rates are jumping to 10 or 15 percent, which they can't afford.

So far, most lenders are handling defaults one slow case at a time. If they offer any help at all, it's a stretched-out payment plan (including late charges and piles of mystery fees). Experience shows, however, that these plans rarely work.

Instead, borrowers need loan "modifications"—meaning changes in the terms. What would help most is holding the payments level. That way, a majority could cover their mortgages and keep their homes. So far, "mods" have been made to only 1 percent of the loans.

At this point, the holier-than-thous are sniffing, "Why let them off the hook? They made their bed, let them be thrown out of it." I agree, for borrowers who told the bank, falsely, that they were going to live in the house but actually bought it to flip. Owners who occupy their homes are another story. Often, they were seduced into buying or refinancing by a slick salesperson who misled them about the risks.

There are two sticking points, says Guy Cecala, publisher of Inside Mortgage Finance.

First, the banks servicing these loans traditionally haven't considered modifications. They'd rather do "short sales" where the owner hands over the keys and walks away.

Second, the institutions that own the mortgages don't believe they have to accept modifications to avoid losses down the road. They're holding AAA-rated bonds backed by these subprime loans. When some go bad, they'd rather foreclose, take their money and run.

But quick foreclosures won't save the bondholders today, says Lewis Ranieri, the man who created the mortgage-backed securities market in the late 1970s. A tsunami of defaults will overwhelm the mortgage servicers in the next few months—setting off death spirals in local housing prices. "Every house that's foreclosed drags down the value of four houses around it," he says. In such a world, even AAA-rated bonds lose money.

Sheila Bair, chair of the Federal Deposit Insurance Corp., sees a way out. She's proposing that the banks automatically modify every subprime loan if the borrower lives in the house and has been paying on time. Payments would continue at the starter rate, without a step-up. That could prevent foreclosure on about 1 million loans, Bair says, freeing overtaxed bank staffs to focus on the borrower's default.

Would Bair's idea help some undeserving people who overstated their income on the loan application? Yep, but there are no good options here. "Lenders are misguided if they expect to ride this out," she says.

They may be starting to see the light. Over the past three months, more loans have been modified, says Mike Shea, head of Acorn, a nonprofit that helps lower-income homeowners. Countrywide, among others, is starting to modify loans by the batch. For those that don't, "the losses could be severe," Shea says.

So here's the message for subprime borrowers who could afford their homes if their interest rate doesn't rise: try to hang on for six months, keeping payments up to date. As the housing disaster deepens, lenders will cut deals that they're avoiding now.