Housing bailout: winners and losers

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(MONEY Magazine) -- What if you've done everything you could to save your house? You refinanced your risky adjustable-rate home loan to a conservative 30-year fixed-rate mortgage. You and your spouse emptied your savings accounts and pulled thousands of dollars out of your 401(k)s.

But still, the payments are more than you can handle, and it looks like you'll lose your home to foreclosure. It makes you wonder why you were approved for a mortgage you couldn't afford in the first place.

Should something be done to help you and other homeowners in the same fix? Banks, prodded by the Bush administration, have already put in place a program to rescue some of the neediest caught up in the mortgage mess.

Americans, however, seem conflicted about extending help to anybody. In a December CNN poll, for example, 51 percent of respondents said that borrowers had dug their own hole and now would just have to dig themselves out.

Before you join this tough-love brigade, however, consider how you might find your own fortunes tossed about in the rising tides of foreclosure. And make no mistake: A deluge is on its way.

Without any intervention, an estimated 3.5 million homeowners could default on their mortgages in the next 2 1/2 years, says Mark Zandi, chief economist at Moody's Economy.com, a West Chester, Pa. economic research firm. That's the equivalent of every family in both Dakotas, Delaware, Hawaii, Idaho, Montana, Nebraska, New Mexico and Wyoming losing their homes.

For starters, a sharp spike in foreclosures will increase the number of houses up for sale; additional inventory in an already glutted market will further depress prices. Second, houses in foreclosure generally fall into disrepair. Clumps of empty, boarded-up dwellings surrounded by weeds lower prices not only in the immediate area but also in nearby neighborhoods. And for every 1 percent increase in the foreclosure rate, a neighborhood's violent-crime rate rises 2.3 percent, according to a study by Dan Immergluck of the Georgia Institute of Technology and Geoff Smith of the Woodstock Institute.

The Center for Responsible Lending, a consumer group, found that an increase of 1.1 million foreclosures would lower the prices of as many as 44.5 million homes by a collective $223 billion. "If we don't help homeowners having problems paying their mortgage, everyone's net worth is going to go down," says Zandi.

Mortgage interest rates would likely shoot up too. Now that lenders - and the investors who bought pools of their loans on the secondary market - have incurred multibillion-dollar losses, they are less willing to grant new loans to home buyers without earning more interest.

Although rates are still relatively low (about 6.2 percent for a 30-year fixed-rate mortgage in mid-December), there's no guarantee they'll stay that way. And Fannie Mae and Freddie Mac, which help finance more than half of the nation's mortgages, have already added a 1.25 percent fee for borrowers - $3,750 on a $300,000 loan.

Finally, rising foreclosures and falling house prices could easily squelch economic activity. The possible consequences: less consumption and production, increased unemployment and ultimately recession.

Given the dire consequences, more and more legislators, political candidates and policymakers are frantic to turn back the wave of foreclosures. In addition to the Bush plan, there are three solutions under consideration. None of the plans is ouchless. As explained below, each produces winners and losers - and long-term effects, both good and bad, on the economy.

The plan: This program, championed by President Bush and Treasury Secretary Henry Paulson, asks lenders to help borrowers with loans likely to cause the most foreclosures in the next few years: 2/28 or 3/27 mortgages. They have a fixed interest rate of, say, 7 percent, for two or three years and then adjust to much higher rates - up to 15 percent. With such a mortgage, an initial $1,995 monthly payment on a $300,000 loan would shoot up to $3,793.

Under the plan, lenders would freeze the initial rate for an additional five years. To qualify, a homeowner must have a credit score under 660 and equity of no more than 3 percent. Supposedly, anyone with a higher credit score or more equity would be able to refinance or continue paying. Those who can't are stuck.

• Winners: Borrowers who qualify will see significant savings.

• Losers: Lenders

• The fallout: The plan will help only about 145,000 to 600,000 of the 2 million whose mortgages are to reset. And there's no assurance that they will be able to handle the new, higher payment five years hence. The plan applies only to mortgages that reset in 2008 or after. If your mortgage rate has already been hiked, no freeze for you.

• The plan: Proposed by Sen. Hillary Clinton (D-N.Y.), the program would halt foreclosures for those with subprime mortgages for 90 days to give them time to work out problems with lenders. After that, interest rates for anyone with a 2/28 or 3/27 loan would be frozen for at least five years. (Her plan excludes mortgages on investment properties or second homes.) After five years, people who still can't afford their rate adjustments would be allowed to apply for government-sponsored mortgages that they could afford.

• Winners: 2 million who face rate resets

• Losers: Lenders would have to swallow losses in interest. Taxpayers would pay to refinance loans for those still in trouble after the freeze lapses.

• The fallout: Forcing lenders to pay for a much bigger chunk of the mortgage cleanup will, in theory at least, reduce their willingness to make loans, particularly at the historically low rates prevailing for the past few years. With mortgages harder or more expensive to get, fewer people may be able to buy homes, causing prices to drop further. "We don't have enough credit right now," says Christopher Mayer, a Columbia University economist. "So the last thing you want to do is make lenders less willing to lend."

• The plan: Bankruptcy judges would have the power to modify the terms of a mortgage so that strapped borrowers could afford to pay, under this proposal from Sen. Richard Durbin (D-Ill.). Lenders would be forced to accept lower interest rates, stretched-out payments or even a decrease in the loan itself.

• Winners: Anybody who qualifies for a Chapter 13 bankruptcy - someone who has enough income to repay a portion of his debts - could see savings on a mortgage loan. Banks would be spared going to court to foreclose, evicting the homeowner and selling at fire-sale prices.

• Losers: Banks complain that they would lose out by accepting lower payments. But if a bank has to go to court to foreclose on a house, evicts the owners and then has to sell the property at a distressed price, it would have to accept lower payments anyway.

• The fallout: Writing down the cost of a loan is an efficient solution for the lenders, according to Chang-Tai Hsieh, an economist at the University of California at Berkeley. "But getting them to do it without a judge is very difficult." Lenders, however, have derisively labeled the bankruptcy approach the "cramdown" plan. And James Lockhart, director of the U.S. Office of Federal Housing Enterprise Oversight, believes it would encourage borrowers to gamble on loans they can't afford because they could eventually have them altered. "It raises an extreme moral hazard," he says. That seems unlikely. Few people would want to go through Chapter 13 bankruptcy, a traumatic process that would require them to live for five years on an IRS budget designed for tax cheats. Paying the mortgage is a whole lot easier.

• The plan: As it did in the Great Depression and in the aftermath of the savings and loan crisis, the government would set up a trust to buy and hold the mortgages of borrowers who couldn't repay their loans. The trust could modify loans, again, by stretching them out, reducing or freezing rates or lowering the amount owed. Ideally, borrowers would repay all the money over time and the trust would dissolve.

• Winners: Most borrowers, who should be able to keep their homes. Banks could use money that the government pumped into the market to make new home loans.

• Losers: U.S. taxpayers would face yet another fiscal woe, at least temporarily.

• The fallout: A study by First American CoreLogic, a real estate information company, estimates that the plan may cost about $120 billion over the next five years. And in the process the nation may have created a new group of government dependents. The government would have to ensure that lenders share the financial pain. Otherwise, they'd have little incentive to be more prudent next time the housing market heats up. And American public opinion has been clear about letting bankers off scot-free. Some 76 percent of the respondents to the CNN poll said that they wanted no helping hand extended to lenders.

News about the rise in foreclosures has focused on so-called subprime borrowers people with low credit scores. They can't qualify for mortgages at all these days. But lenders have also tightened terms for people with good credit albeit gently. Here are the changes you'll see if you're shopping for a home loan.

No more no money down Good-bye to 100 percent financing; you'll have to save up a down payment or get it out of your current home. Big banks like Wells Fargo now require a down payment of at least 5 percent of the property's value, and in markets where housing prices are falling, they insist on 10 percent. Want to renovate? You'll be able to get a home-equity line of credit or a second mortgage only if your equity is at least 10 percent of the value of the property.

Jumbo loans get pricier A jumbo mortgage - that is, a loan of more than $417,000 - always costs a little more than a regular one, usually an extra 0.25 percent to 0.5 percent. The reason: Government-backed bond investors Fannie Mae and Freddie Mac won't purchase mortgages over that amount. Now private investors are backing away from jumbos too. If you need one, you'll pay a full percentage point extra, about 7.1 percent as of mid-December.

Say hello to credit pricing Lenders once used credit scores to determine whether you were approved for a mortgage, not the interest rate you'd pay. Already Fannie and Freddie are charging borrowers with a credit score of less than 680 an additional 1.25 percent of their mortgage as an up-front fee. In the future, lenders will graduate interest rates and fees from the bottom (300) to the top (850) of the credit score range.