On July 31, President Bush signed legislation that is intended to provide relief for thousands of Americans in danger of losing their homes to foreclosure. In this article, Ill provide a brief explanation of what led to the legislations enactment, the details of how it works, and who will benefit from it.



Why It Happened

In the last year, the housing market has been crippled by a severe credit crunch, caused in part by subprime loans gone bad. During the housing boom, a lot of loans were made to people who couldnt make a normal down payment and couldnt realistically afford their monthly mortgage payments. These subprime borrowers got loans because salespeople were paid for making loans, regardless of whether they were good loans or bad loans.





Many subprime loans were a foreclosure waiting to happen, and these forced sales are fueling a vicious cycle in the real estate market, with foreclosures dragging down prices and slumping prices encouraging people to walk away from mortgages bigger than the value of their homes.



How the Law Works

The housing rescue bill is intended to break this cycle by avoiding unnecessary foreclosures without simply throwing money at banks and borrowers. Like most laws, the goals are simple but the details are complex because the law tries to anticipate every possible contingency and abuse. The result is a 694-page bill. A six-page summary is at http://banking.senate.gov/public/_files/HousingandEconomicRecoveryActSummary.pdf



The most important part of this law authorizes the FHA to insure distressed mortgages if the bank replaces the existing loan with a 30-year, fixed-rate mortgage equal to 90% of the homes current value. For example, if an at-risk borrower has a $210,000 mortgage on a home that is only worth $200,000, the bank could convert this loan to a $180,000 fixed-rate mortgage.



Here are some additional details on how the law works:



1. The law only applies to owner-occupied homes purchased between January 2005 and June 2007.



2. The current mortgage payments must be at least 31% of the households gross monthly income.



3. The household must pay off any other debts on this home, such as a home equity loan, before receiving a new loan and must not take out a new home equity loan unless it is needed to repair the home. A new home equity loan must be approved by the FHA and the total debt on this home cannot exceed 95% of the homes value.



4. The lender will obtain an appraisal of the homes current value and issue a new loan equal to 90% of the homes appraised value. The lender will waive any fees and penalties from paying off the existing mortgage and accept the new loan as a paid-in-full replacement for the existing mortgage.



5. The lender must verify the borrowers income, wealth, and credit score in order to determine if the borrower is likely to make the new monthly mortgage payments.



6. If the borrower sells the home or refinances the mortgage, they will pay the FHA an exit fee equal to 3% of the mortgage balance and a share of the profits if home prices increase (100% if done within a year, 90% if within 2 years, and so on down to 50% if in the fifth year or later).



Who Benefits?

The banks incentive is that it avoids an expensive foreclosure and obtains FHA insurance that the monthly payments will be made; the banks cost is that it takes a loss on the distressed loan and must pay the FHA a fee equal to 3% of the homes appraised value. The homeowners incentive is that he or she gets a fixed interest rate on a smaller loan; the cost is that the homeowner must pay the FHA 1.5% of the new loan balance each year and share any profit it realizes from the home with the FHA.



This is a voluntary program, so homeowners and banks must decide if a new loan makes sense. Homeowners are most likely to benefit if they are struggling with their current mortgage payment, but can afford smaller payments. Banks are most likely to benefit if they would suffer a large loss by foreclosing. It is predicted that some 300,000 to 400,000 homeowners will participate.



This bill is obviously good news for people who can use affordable government-backed loans to keep their homes. It is also good news for the real estate market. In most U.S. cities, a home is still a great investment. With prices down and a glut of homes on the market, now is also a good time to be a home buyer. If this housing bill gets credit flowing again, everyonehome buyers, home sellers, and home ownerswill benefit.