Is the cavalry coming to rescue troubled homeowners?

Despite soaring foreclosure rates, President Bush and other Republicans have not made this a top priority, and Treasury Secretary Henry Paulson has refused to draw on the $700 billion rescue fund to help homeowners, saying that saving financial institutions is more important. But this could change next year: President-elect Barak Obama and fellow Democrats say reducing foreclosures is crucial to attacking the financial crisis and economic downturn.

"The financial sector weaknesses all originate in the housing market," says Jack M. Guttentag, professor of finance emeritus at Wharton. "If we don't solve the housing problem, then the weaknesses in the financial sector are going to continue to multiply."

Testifying November 18 before the House Committee on Financial Services, Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., agreed: "Minimizing foreclosures is essential to the broader effort to stabilize global financial markets and the U.S. economy." According to Wharton real estate professor Susan M. Wachter, it is essential to break the vicious cycle of foreclosures driving down home prices, spurring more foreclosures. "The housing crisis is still a major source of the broader economic crisis that we find ourselves in."

Other experts are not so sure. "I wouldn't bail out people who made stupid mistakes," says Kent Smetters, professor of insurance and risk management at Wharton, arguing that borrowers and lenders should suffer the consequences of risks gone bad. Trying to mitigate the consequences won't stop the financial train wreck, just shift it to slow motion, he argues.  "The alternative is to say we're going to let the train wreck happen. What that does is to allow us to clear the tracks sooner."

On November 26, the Federal Reserve and Treasury Department announced an $800 billion infusion in the credit markets, including $600 billion to buy debt issued by mortgage giants Fannie Mae, Freddie Mac and the Federal Home Loan Bank. The move immediately drove the interest rate on 30-year fixed-rate mortgages down to about 5.5% from 6%, and there were reports of a flurry of loan applications from people looking to refinance mortgages or buy homes.

Wachter said the move is a key step to reviving the housing market and eventually stopping the downward spiral of home prices.

The lower rates could help some homeowners cut monthly payments by refinancing, perhaps allowing some to stay in homes they otherwise would lose. But lower rates alone will not help many homeowners who owe more than their homes are now worth, because these borrowers will not qualify for new loans big enough to pay off the old ones. Reducing the number of expected foreclosures would probably require efforts tailored to this problem, such as a recent program proposed by the FDIC's Bair. Even if such programs are enacted, it is not clear how well they would work.

A key problem: Can enough investors in mortgage-backed securities be induced to lock in losses, or will they prefer to hold out for a market rebound? Reduced interest rates and write-downs in loan balances are central to many foreclosure remedies.

Loan-modification advocates say those investors will go along, since a modification that costs mortgage investors 20% to 30% is preferable to a foreclosure, which typically costs more than 50% of the original loan amount. But skeptics note that not all investors in a given mortgage pool would benefit from a modification even if the pool as a whole is made healthier, since investors with first rights to homeowners' monthly payments are better insulated from defaults than those at the back of the line.

There is also debate over whether loan servicing companies that receive homeowners' payments and disburse them to investors have the authority to agree to sweeping modifications. William Frey, chief executive of Greenwich Financial Services, a firm that creates and distributes mortgage-backed securities, says servicers have little leeway. "The problem is there was a failure to imagine the kind of catastrophic meltdown that we have had," he notes.