How to stop the foreclosure 'death spiral'

This post comes from Marilyn Lewis at MSN Money.

Respected mortgage analyst Laurie Goodman is speaking out about what she sees as the danger of letting the housing bust fester.

She's profiled in Money Magazine along with her proposal for what the magazine calls "The one bailout America could really use." 

Goodman, who's studied "the minutiae of mortgage-backed securities for big investment banks" for 28 years, works at Amherst Securities, an Austin,Texas-based broker of those securities to big investors.

She's proposing a solution to the mortgage problem that's dragging home prices down.

But first, the problem and its severity: Goodman says if nothing is done to stop foreclosures, 10 million mortgages could be sucked in by 2018 -- 18% of all outstanding home loans.

And that's just if price declines don't get any worse in the next 12 to 18 months.

So far, says Goodman:

• 2.5 million homes have been lost to foreclosure.
• 4.5 million additional homeowners have stopped paying their mortgages.
• Millions more people are "under water" -- their mortgages are worth more than the homes, giving them an incentive to "strategically default" (walk away).

That's dangerous for the country -- and for Goodman's clients. She warns of a "potential housing 'death spiral'" in which foreclosures keep pulling down home values, causing more strategic defaults, which create more foreclosures, which keep sucking value out of housing.

Here -- to illustrate -- is the problem facing mortgage holders whose home is 20% underwater, even if prices stopped falling right now and rose 2% to 3% this year:

• It would take eight to 10 years to pull even on the investment.
• If the owners sold, they'd lose about 10% of the sale price to taxes and agents' fees.

The problem with modifications

Banks and the federal government, through its Home Affordable Modification Program, cling to mortgage modifications as a solution. But modifications don't appear to be working well. They rarely reduce mortgage principal. Instead, they extend the time to pay back the loan, kicking the problem of an unsustainable debt amount down the road.

Banks and HAMP completed some 1.76 million mortgage modifications in 2010 and about half that last year (due to a slowdown in processing foreclosures).

Nearly 30% of homeowners with HAMP modifications defaulted again within a year, HousingWire reports. Post continues below.

Private bank modifications performed worse: Among the 129,000 modifications made in early 2010, more than 34% went two months without a payment during the first year, according to the Office of the Comptroller of the Currency.

Goodman's idea is to persuade banks to forgive the underwater part of the debt in exchange for sharing any future home appreciation:

To avoid the "moral hazard" of rewarding foolish borrowers, Goodman recommends that lenders swap immediate principal reductions for shares of any gains on the mortgaged house when it is sold.

Many mortgage holders, including giants Fannie Mae and Freddie Mac, are refusing any kind of principal-reduction deals, however. Some don't want to have to take the immediate write-downs that would be required, preferring to delay the financial pain and hope for a rebound.

Goodman, familiar with the logic and incentives of mortgage servicers -- the bank arm or contracting company that collects payments and enforces foreclosures -- told the magazine:

… investors lose as much as 70% when the homes underlying their subprime MBS (mortgage-backed securities) are foreclosed upon. Lenders that tried to rehabilitate delinquent borrowers by reducing the principal (or total amount owed) by an average of 26% were far less likely to have to foreclose.

But the banks aren't motivated. They're "riddled with conflicts of interest," Goodman says.

"Many of the rules in place now are extremely large-bank-friendly,​ but borrower- and investor-unfriendly,​" she adds. For example:

• Fees for servicing loans are linked to the amount of the loan's principal, so reducing the principal would reduce the fee.
• Reducing principal often means the servicer takes a loss on a second mortgage tied to the loan.

The idea of a "shared-appreciation​ mortgage" dates back 40 years, says a 2008 Wall Street Journal article by four guest writers, "We can keep people in their homes: Let lenders profit later for easing terms now":

The SAM was pioneered by banks in the U.S. some 40 years ago, but it has been allowed to languish due to an archaic, IRS-imposed block. (The IRS hasn't ruled whether such a contract is a mortgage because it combines elements of equity and debt.) This block could be removed at the stroke of the Treasury secretary's pen.

This 2006 article by HSH.com, a mortgage information provider, details the history and mechanics of SAMs and of the IRS impediment.

The Journal compares SAMs with the 30-year, fixed-rate mortgage, an innovation that helped pull homeowners out of unmanageable debt in the Great Depression:

Today, facing a similar collapse, the federal government needs to be equally bold. SAMs are the new deal in housing that our children need.

Another backer of the SAM idea, according to Money Magazine: Nouriel Roubini, an economist credited with predicting in 2007 that the U.S. housing bubble would burst.

Goodman sounds somewhat hopeful that SAMs still might catch fire, according to Money:

At least one private servicer, Atlanta-based Ocwen Financial Corp., has started to try this "share the pain and gain" option. "Progress is slow," Goodman says, "but I feel like I am getting some traction."

More on MSN Money:

• Pay off your mortgage in 2012?
• Calculator:Should I refinance?
• Is your foreclosure eligible for review?
• New record mortgage rate lows
• There's life after bailing on a mortgage
• How much house can you afford?