Home loans in the US: the biggest racket since Al Capone?

The Obama administration today unveiled the Homeowner Affordability and Stability Plan – measures to help financially challenged homeowners to avoid foreclosures.  The program has three key components.  The first is $75 bn of Federal government money to subsidise the modification of home loans (I believe $50bn of this was already in Treasury Secretary Geithner’s earlier announcements on the Financial Stability Plan).  The Federal government is also making an additional $200 bn of capital available to Fannie Mae and Freddie Mac, so they can expand their mortgage lending and guarantee activities.  The second is to “Institute Clear and Consistent Guidelines for Loan Modifications”: a standardized framework for dealing with troubled mortgages.  The third is an overhaul of bankruptcy laws to allow judges to force the writedown of principal on mortgages for bankrupt homeowners or to force lenders to reduce mortgage rates.

Are there too many foreclosures?  What determines the socially optimal number of foreclosures?  Foreclosure is the taking by the creditor of the collateral offered for a loan, following a default on the loan by the borrower, and the sale of that collateral by the creditor so he can recover what is due to him.  We have foreclosures because there is collateral and because there is uncertainty about the future financial circumstances of the borrower.  We cannot eliminate all uncertainty about the future financial circumstances of the borrower.  Still, there are several ways to eliminate foreclosures altogether.

The first would be to forbid offering residential real estate as collateral (or at any rate to forbid the offer of an owner-occupied home as collateral for a loan).  Home loans (in the sense of loans to purchase a home with) could be unsecured, or secured against other assets.  Alternatively, households would have to save up the full purchase price of the property.  Finally, you could stipulate that a mortgage could only be given with 100 percent mortgage protection insurance attached – covering all contingencies (death, disability, ill-health) that might impair the ability of the mortgage borrower to service the mortgage.

This eliminates foreclosures but would also seriously reduce home ownership.  So let’s try something else.

What are the costs of foreclosure? Who bears them?  Are the private costs smaller than the social costs?

Transaction costs

Foreclosure is step in a well-understood contractual arrangement – a change of title happens: the house that was mine is now under the control of the mortgage lender who can sell the property to recover the sum owed to him.  As it happens, foreclosure eats up a lot of real resources: time, lawyers’ fees, bailiffs, other legal fees, surveyors’ fees, etc.  This is a real resource cost, not the redistribution of property rights.  It has been estimated at between $50,000 and $80,000 per foreclosure.

The transaction costs associated with foreclosure are outrageous.  It clearly makes mortgage lending a less profitable attractive activity to engage in and reduces the size of the mortgage market.  It makes sense, from a social efficiency point of view, to make foreclosure cheaper and easier.  This could be achieved most easily be strengthening the rights of the creditor (the mortgage lender) vis-à-vis those of the debtor (the mortgage borrower).  The proposals that I have seen, however, all want to make foreclosure more difficult, by entrenching the owner-occupier more securely in the family home.

Neighborhood blight

Another cost often attributed to foreclosure is ‘neighbourhood blight’, that is, negative externalities associated with foreclosures and the associated repossessions and evictions. The value of neighbours’ properties goes down and pretty soon the weeds are growing through the cracks in the pavement, homes are boarded up and the entire neighbourhood risk going down the snyrting.  This argument makes no sense and appears to be an example of confusing association (or correlation) with causation.  What is likely to have a stronger negative effect on the value of neighbouring properties: an owner-occupier who can no longer afford the mortgage he has taken on, or the forced sale of his property to someone who can afford it?  The answer seems pretty clear.

Declining, blighted neighbourhoods are likely to be found in regions that are in economic decline, like parts of the American Mid-West.  In such regions, there are likely to be more existing homeowners who lose their job or become worse off for other reasons and who as a result cannot keep up with their mortgage payments and face foreclosure, than there are would-be home owners ready to take on a mortgage and buy a home.  So rising foreclosures are likely to be followed by periods during which more properties stand empty, inviting vandalism or use as a crack den.  The neighbours try to move away from such toxic properties and the blight spreads.  The fundamental driver of all this is, however, the economic decline of the region.  Foreclosures do not cause neighbouring property values to fall.  Both foreclosures and declining property values are driven by broader economic conditions.

Wailing waifs

One reason foreclosures are so politically sensitive is that they are associated with the dispossession of owner-occupiers and the eviction of families.  Distraught parents standing on the stoop of what used to be the family home, clutching a few meagre belongings.  Crying children.   There is even a sub-conscious association of foreclosures with homelessness.

Foreclosures don’t just involve owner-occupiers, however.  Buy-to-let owners have mortgages also.  But let’s leave that aside.  The reason that foreclosures involving owner-occupiers are an issue has to be either that (even after allowing for the transaction costs of foreclosure), the value of the home that is lost to the owner-occupier is greater than the value of the home to the bank and/or that there are serious distributional or poverty issues associated with foreclosure.

There may be something to the first of these points.  To most people, a home is more than a hotel room.  It becomes part of what you are – it gets under your skin.  I am quite willing to believe that.  I don’t, however, believe that this emotional attachment to the place you live in is identified with owner-occupancy.  Until I was 21 years old, my parents always lived in rented accommodation.  We spent 14 years in the same rented place in Brussels.  It was very important to me – it was our ‘home’ – and even now I often remember it.  I also remember quite well the (rented) house we lived in for two years in Luxembourg.  I was eight when we left; I cried my eyes out, in part because I really loved that house.  Are we going to give tenants special rights and financial assistance because the place they rent is worth more to them than it is to their landlord?

If foreclosure leads to poverty, that poverty may be of concern to and a responsibility of the state, but only because it is poverty, not because it is poverty due to a specific event or cause – foreclosure.  I believe a civilised, compassionate society tries to eliminate poverty.  It does not have a special policy for eliminating poverty suffered by former owner-occupiers who have lost their homes because of foreclosure.

Homelessness is a curse.  But it is a curse regardless of whether homelessness is suffered as a result of an owner-occupier and her family experiencing foreclosure and eviction, as a result of a tenant being evicted by his landlord, as a result of divorce or mental illness, or as a result of a natural disaster or a war.  In addition, only a small fraction of foreclosures leads to homelessness.  Most victims of foreclosures manage to find cheaper accommodation.

Is home ownership is ‘a good thing’?

Why do politicians of all political colours and parties get their knickers so twisted about people losing their homes?  In the case of the Tories in the UK and the Republicans in the US, the answer is obvious.  Both parties believe that home owners are conservative.  Not it the sense that people who are inherently conservative are more likely to become homeowners (although they may believe that as well).  This is not a selection story but an osmosis story.  Home ownership makes people more conservative.  So both Tories and Republicans do everything they can to encourage home ownership.

But so do (New) Labour in the UK and the Democrats in the US, so it’s no longer a left-right thing.

The one argument for encouraging home ownership that makes sense is that owner-occupiers look better after their property and its immediate surroundings than would a tenant.  This is a simple principal-agent story where it is costly for the principal (the owner) to monitor the care and attention the agent (the tenant) bestows on his property.  Add some neighbourhood externalities (I don’t want to live next door to a place where they don’t mow the lawn or paint the exterior of the house), and you have an argument for encouraging owner-occupancy, say by subsidising it.

Subsidise owner-occupancy if you must, not borrowing secured against residential real estate

But a subsidy for owner-occupancy is something completely different from subsidising borrowing using residential real estate as collateral.  If they exist, the benefits from owner-occupancy are there regardless of whether the owner-occupier has a mortgage or not.  It doesn’t matter whether she borrowed to buy the house, paid in cash, stole it, inherited it from her parents, or built it with sweat equity on land won in a raffle.

The US does not encourage owner-occupancy directly, say by paying each head of household who is an owner-occupier, a given amount of cash each year.  Instead it encourages and subsidises a particular form of borrowing, regardless of what that borrowing is spent on.  Funds, after all, are fungible.  I can withdraw equity from my house by taking out a first or second mortgage against it, or by increasing the size of an existing mortgage, and spend the proceeds on Cuban cigars.

All this is rather insane.  Through the deductibility of mortgage interest from taxable income, the US tax payer gives vast subsidies to borrowing secured against a particular type of collateral – residential real estate.  What so special about this borrowing and this collateral?  Fortunately, the UK has abolished this boondoggle.  In the US, other forms of preferential treatment for home ownership are piled on top of the mortgage interest-deductibility.

Over half the stock of home loans, and virtually all new home lending in the US are heavily subsidized by the lending and guarantees of Fannie Mae, Freddie Mac, Ginnie Mae and assorted aller smaller government agencies.  The direct interventions of the Fed and the Treasury in the market for residential mortgage-backed securities, announced as part of the credit-easing policies of the FEd represent further quasi-fiscal subsidies to housing finance.  This is on top of the creation by the Fed of at least a dozen facilities that accept RMBS as collateral for Fed loans in the earlier stages of the financial crisis. All these quasi-fiscal interventions by the GSEs and the Fed are deeply non-transparent as regards the magnitude of the subsidies involved.  They also evade the normal scrutiny and accountability to Congress that is associated with explicit subsidies by the Treasury.

The only priviliged treatment of residential housing that makes a modicum of sense from the perspective of encouraging owner-occupancy (as opposed to borrowing to fund whatever expenditures using residential housing as collateral), is the ability to postpone capital gains taxation on the sale of one’s principal residence, and to have one capital-gains-tax-free realisation during one’s lifetime (taken generally when people size down on retirement or when the kids have flown from the nest).

The bloated US housing stock

The extreme fiscal largesse bestowed on residential housing, directly and indirectly through mortgage interest deductibility, has led to a massive misallocation of investment in the US.  There has been overinvestment in the private residential housing stock and underinvestment in just about every other form of fixed capital: infrastructure, public amenities of all kinds (sports facilities, public recreational facilities, parks etc.), commercial structures, plant and equipment.  It is time to correct the distorted incentives that are at the root of this misallocation.  The easiest way to do this, in the current tax system, is to end the deductibility of mortgage interest in the personal income tax, close down Fannie and Freddie and end the role of the US government in the provision of residential mortgages.  A focused social housing program is of course a legitimate activity of the Federal government.  It should be on-budget, that is, fiscal rather than quasi-fiscal.

The $275 bn hand-out

The Obama administration is going to ease the burden on existing financially challenged mortgage borrowers.  As much as $75 bn will be used to compensate the lenders – the banks or to bribe them into accepting easier financing terms for financially stressed borrowers.  That’s nice.  It will, of course, encourage moral hazard.  People who have mortgages that have become too large for them to service and who have not bothered to purchase the right kind of mortgage protection insurance are getting ex-post free mortgage protection insurance from the tax payer.  It will encourage future reckless borrowing by would-be home-owners with residential ambitions larger than their wallets.  It is tax on the prudent to subsidize the imprudent.  It is both inefficient and unfair.  Fannie and Freddie will expand their lending and guarantees thanks to the addition capital provided by the Treasury.

A simpler, standardised framework for dealing with troubled mortgages would be welcome, as it could reduce the cost of foreclosures and also the cost of voluntary renegotiations of the terms of the mortgage contract between borrowers and lenders.

It is especially important that an end be put to those complex securitisations of residential mortgages that make it effectively impossible to renegotiate individual mortgages that are bundled with thousands of other mortgages and God knows what else down seven layers deep in some CDO.  I would favour simplifying the procedures for foreclosure to reduce their cost.  Increasing creditor rights, limiting the grounds for appeals by the borrower and other measures speeding up the foreclosure process would make mortgage lending a more profitable and attractive activity, and would also make lenders willing to consider application by more risky borrowers.

Modifying bankruptcy laws to allow judges to force the writedown of mortgages looks like a prime example of populist pandering and insider or incumbent protection.  It will hurt future mortgage borrowers. Those who already have their home loans will like it.  Those who won’t be able to get a home loan in the future because of these measures will probably blame the banks rather than the politicians that brought in these inane laws.

Especially when judges are elected, as they often are in the US, I hate to think of the political shenanigans that will be the inevitable outcome of greater judicial discretion in forcing lenders to accept writedowns of their loans.  Judges in the kinds of courts that deal with distressed mortgage lending are unlikely to have invested in a Ph.D. in Law and Economics.  They are likely to be lawyers – full stop – and not very good lawyers at that (is ‘not very good lawyers’ an oxymoron?).  They know nothing about markets and incentives, valuation and credit risk.  They will make future mortgage lending much riskier and much more costly for the lender.  Only the best risks will be able to get loans.

The quasi-socialised, opaque system of residential mortgage financing in the US is wasteful and distortionary to a degree that is truly staggering. How can this grotesquely distortionary and deeply unfair system be killed off when so many undeserving over-indebted homeowners who also happen to be marginal voters, so many politically well-connected interest groups and so many influential politicians all have their snouts in the trough? It is clear that the Obama administration far from using the opportunity sent by the crisis to cut the mortgage monster down to size, is instead feeding it and beefing it up further.

The fiscal and quasi-fiscal costs of this massive subsidization of residential mortgages will become apparent during the years to come, as mortgage related government expenditures rise and revenues fail to materialise. But that will be then – sometime in the future. This is now. And now always wins. Myopia, opportunistic behaviour and insider protection: welcome to US home financing policy.

But that will be then – sometime in the future.  This is now.  And now always wins.  Myopia, opportunistic behaviour and insider protection: welcome to US home financing policy.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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