The cardinal principle of the Obama Way of Governance is that he will never use a stick if he thinks he can get away with a carrot. This has been clear since the early days of the presidential primary, when he criticized Hillary Clinton for her plan to mandate that people purchase health insurance. It's been the tragic flaw in the administration's (mis)handling of TARP funds. Yet in crafting a policy to keep homeowners out of foreclosure, the White House seems to have gotten the mix of carrots and sticks just about right.
If that comes as a surprise, it's likely because reaction to the plan came to be dominated by Rick Santelli's rich-guys-gone-wild rant on CNBC. But the stakeholders most invested in the proposal greeted it with near-unanimous approval. The chief economist for the National Association of Realtors told me its provisions for underwater homeowners were "superb." The Center for Responsible Lending (CRL), which sounded some of the earliest warnings about abusive practices in the subprime market, called it "a huge step forward for the entire country." "It's absolutely very carrot-driven," says housing expert Alyssa Katz, author of the forthcoming Our Lot: How Real Estate Came to Own Us. "In some ways it's a brilliant plan."
The mortgage crisis is exactly the kind of problem that's right in the Obama policy shop's wheelhouse. Foreclosure is a lose-lose-lose. It's devastating for the families, expensive for lenders and bad for the neighbors who see their property values decline. In other words, loan modifications, in which lenders lower interest rates, are logical for all parties.
The Bush administration responded to this set of facts by shrugging its shoulders and left it to industry to create a voluntary loan modification system. The result was the Hope Now Alliance, which consisted of a hot line and not much else. It was a flop: according to CRL, only an estimated 20 percent of Hope Now loan modifications result in reduced payments. ACORN's Austin King, who has been advocating on behalf of imperiled homeowners for years, calls Hope Now a "national joke with a tragic punch line." He adds that it "isn't just useless; it's counterproductive."
The Obama policy-makers recognized that although it's in everyone's interest to make large-scale loan modifications, that doesn't mean it will just happen automatically--it will happen only if government steps in to create incentives. Loan servicers, for example, are entitled to collect fees in the event of foreclosure but not for processing loan modifications. So the new policy gives servicers who initiate a modification a $500 bonus.
Similarly, loan modifications that have been enacted typically have brought the monthly mortgage payment down to around 38 percent of a homeowner's income. But this is still a heavy burden for families struggling with other payments, and within six months, 55 percent of modified loans are again delinquent. Under the White House proposal, after lenders get the loan down to 38 percent, the government helps subsidize the mortgage payments to bring them down to a more manageable 31 percent of income.
"After years of banging our heads," King tells me, "we finally have a federal government using all of the tools in its tool belt." King was serious about all the tools. Unlike the mortgage bankers and others who admired the proposal's elegant nudges, King was most enthusiastic about the parts of the proposal that promised a stiff shove.
The first, King says, "is the judicial modifications." For several years ACORN, CRL and Congressional progressives have pushed for a reform to bankruptcy law that would allow judges to modify mortgage terms on a primary residence. On the campaign trail Obama had signaled support for the proposal, but since becoming president, King notes, "he's rolled us on this twice. On the first TARP debate, he said we should not include bankruptcy protection. Then on the stimulus, he said we should not include bankruptcy protections. And a lot of us worried that his objections were more substantive than procedural." In his housing speech, however, Obama finally made his support for the reform clear; the House, at the time of this writing, is poised to bring it to the floor.
"The other stick," King says, is finally attaching some mandates to the "boatload of money we're putting into Wall Street." The plan will require bailed-out firms to put in place a system for across-the-board loan modifications similar to that implemented by the FDIC with the now-defunct IndyMac. Those modifications haven't been a panacea, but they have already modified 11,000 loans, saving investors and lenders $49,000 per loan.
This is all significant progress over the callous inaction of the Bush administration. But though the Obama foreclosure plan threads the needles of the various interests, there is still a lot of painful stitching left. The main problem at the heart of the real estate and financial crises is that hundreds of billions, perhaps trillions, of dollars that were once part of the economy now aren't.
Former IMF chief economist Simon Johnson recently wrote that in his experience with financial crises around the world, resolution can come only when the entrenched power of the big banks is dislodged. "Fully escaping the grip of crisis," he wrote, "really means breaking their power."
You can't do that with carrots. The sooner the White House realizes that, the better.