by ADAM J. LEVITIN

The United States is in the midst of the most serious home foreclosure crisis since the Great Depression, when Franklin Delano Roosevelt spoke of “one-third of a nation ill-housed, ill-clad, ill-nourished.” Over a million homes entered foreclosure in 2007 and another 1.2 million foreclosures were started in the first half of 2008. By the end of 2012, around 8.1 million homes, or 16% of all residential borrowers may go through foreclosure. Millions of Americans have become trapped in unaffordable mortgages due to interest rate resets and declining home values that make refinancing impossible.

Foreclosures create enormous deadweight economic loss. Lenders lose a large percentage of their loan value, families lose their homes, and negative externalities abound. Neighbors see their home values fall; local tax bases are eroded, requiring either higher taxes or reduced services; foreclosed properties become eyesores and loci of crime and fire; and communities’ social bonds are ripped apart as families have to relocate.

Yet despite its inefficiency and social harm, there seems to be no sign of foreclosures abating. Voluntary private market solutions to stem foreclosures have failed to keep pace with new foreclosures, and official government programs, based on private market cooperation, have been abject failures. The FHASecure program, created to allow homeowners with non-FHA adjustable rate mortgages to refinance into FHA fixed-rate mortgages, has only helped a few thousand delinquent homeowners,5 not the 240,000 predicted. Likewise, the HOPE for Homeowners program, established by Congress in July 2008 to permit FHA insurance of refinanced distressed mortgages, and predicted to help 400,000 homeowners, had as of mid-December 2008 attracted only 312 applications, and not actually refinanced any mortgages, in part because of its reliance on private market cooperation.

At first blush, the private market’s failure to resolve the foreclosure crisis is puzzling. When a single lender owns a loan, it will modify the loan in order to keep it performing as long as the modified loan minus transaction costs performs at a level above what would be realized in net in foreclosure. If lenders lose 50% in foreclosure, why aren’t they reducing interest rates and writing down principal balances and stretching out amortizations to make the loan perform at 51% of current net present value?

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