Recently, Barack Obama announced a pair of executive actions, one related to mortgage loans and one related to student loans. Let’s take a look at these two actions separately before we look at how they’re related.
First, the mortgage plan is an effort to help people be able to refinance and take advantage of these historically low interest rates. That’d be a great thing for millions of homeowners if they could because they’d be able to shave hundreds off their monthly mortgage payments. We all know how big of a problem the housing market is right now.
It’s useful to think of credit in terms of 3C – character, capacity, and collateral. They’re measured by credit score, a debt/income ratio, and other assets like home equity, savings, etc. Over the past few years, all three requirements have tightened up and reverted back to historic norms. From the late 1990’s well into the 2000’s, we had a nationwide relaxation of credit standards for housing, which we’ve begun to undo over the past couple years by returning to those historic norms. Gone are the days where no minimum credit score, proof of income, and down payment are required. Now, just like in the days of yore, people need higher credit scores, higher documented incomes, and down payments. This tightening of requirements back to the historic (and proven effective) norm is a big deal because the people who need mortgage modification the most are the ones with subprime loans. They ended up with subprime loans because of a low credit score, low and/or undocumented income, and/or low/no collateral.
But, here’s the thing. In the program’s current form, I don’t think many will be able to take advantage. The criteria for eligibility are far too stringent based on 3C. Credit scores and documented income will be issues on a case by case basis, but two other requirements worry me. The ratio of the loan amount to the value of the house, or loan-to-value (LTV) ratio, cannot exceed 125%. It may be able to eventually, but not yet. Such a low LTV ratio won’t do much good in the worst housing markets like California, Nevada, and Florida. It’s simple math. If you buy a house and its value gets cut in half, as has happened in many of the aforementioned trouble areas, the LTV is going to be 200%. Obviously, it’ll be lower if we assume some down payment and principle reduction, but it’ll still likely be well above even the 125% level. Lastly, and this is a big deal, the mortgage must be current, meaning no payments over 30 days past due in the past year. This is an important characteristic because it makes it so that the taxpayers are helping people who are trying their best to stay current in their payments versus helping squatters who stopped paying a long time ago. It’s a necessary trait, but it will diminish the program’s effectiveness because it’s a huge hurdle to clear.
Next, we move onto Obama’s student loan action. Starting in 2012 under the plan, borrowers will be able to reduce their monthly payment from 15% to 10% of discretionary income, debt would be forgiven after 20 years instead of the current 25 years. It will also allow borrowers to consolidate their loans to obtain lower rates.
We hear the numbers about how dire the student loan situation is and we’ve heard the calls that higher education is the next bubble to burst, so I’m not going to belabor that point. We all know this is a major issue. The debt is overwhelming and it will suffocate our economy if we allow it to.
As with the mortgage plan, the devil is in the details. Note that we are talking about discretionary income, not total income. Discretionary income is a subset of total income. Discretionary income is generally defined as income left after taxes and personal necessities have been paid. Because of this key distinction, it cannot be thought of as an instant 5% raise to borrowers. Again, it’s simple math. Suppose discretionary income is 20% of a person’s total income. A reduction from 15% to 10% of discretionary income sounds like a lot, but it only translates to a 1% gain in total income. A gain in income is a gain in income, but I don’t think it’s that big of a deal.
Shortening the duration of loans from 25 years to 20 years will have no meaningful effect, either. Yes, college costs have been handily outpacing inflation for a couple decades, but the major increases in student debt really only began within the past 10-15 years (not coincidentally, as the costs of college have spiraled even further out of control). A meaningful chunk of student loan debt won’t go away for another 5-10 years under this plan, versus 10-15 in the current plan. The timelines just don’t mesh right now to make this effective.
Consolidating college loans into lower rates is also generally not going to be that effective because many college loans are at very low rates to begin with. Because the rates are generally very low, the concept of diminishing returns becomes an issue (this would apply for the mortgage program, too, but it would be even more pronounced here because the rates are generally lower). The rate reduction would be minimal and all that would really be gained here is the convenience of only having one bill.
What common connections do I see between these two plans?
First, these plans are nothing new. The mortgage plan is a modified version of Obama’s previous mortgage plan and the student loan plan is merely an acceleration of the timetable of an existing plan from 2014 to 2012. Along with his jobs bill, this is further evidence that Obama is simply not willing to try anything new and merely continues to tweak or expand existing ideas.
Second, as I’ve outlined above, I question the effectiveness of both plans. Because I do not view either program as terribly effective, I could take two lines of thought. I could say that it’s because he can only do so much without Congress. Given the blatant disregard for the rule of written law Obama has displayed throughout his presidency, I don’t see this as an issue. Instead, I naturally suspect this is yet another case of Obama wanting to look like he’s doing something, but in actuality doing nothing. It’s all about reelection and perception trumps reality.
Third, I view both of these measures as clear efforts to pander to the Occupy Wall Street (OWS) crowd because student debt and mortgage debt have been two central issues for that movement. It’s an effort to energize Obama’s base. Young voters (early 30’s and younger) tend to be overwhelmingly Democrat or liberal, with the 2008 election being a notable example. I hope OWS is smart enough to see this for what it is, and many of them probably are.
I know I’ve only pointed out the flaws with Obama’s actions here and not provided viable solutions of my own. My solutions are out of scope for this post and I will provide them in the future. In a nutshell, these two measures are focusing on merely the symptoms and papering over the problems versus actually addressing the root cause of both the housing and college issues, but like I said, that’s another topic for another day. The bottom line is Obama has put forth actions to address two major problems, mortgage debt and student debt, that will prove ineffective and were only implemented to help his reelection by creating the appearance that he is trying to solve problems
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