February 25, 2008
America needs a way to stem foreclosures
By Lawrence Summers
The American economic outlook remains highly uncertain. But macroeconomic policy is now properly aligned, as the economy will benefit over the next several quarters from fiscal and monetary stimulus. To the extent conditions warrant and inflation risks permit, monetary and fiscal policy are appropriately poised to provide further stimulus.
Policy towards America’s failing housing sector is in a far less satisfactory state. All honest analysts accept that policies adopted so far, such as the “teaser freezer” limits on resetting mortgage interest rates and increased federal support for mortgage lending, have had only a marginal impact on what may be the most serious crisis in housing finance since the Depression.
It appears house prices are down by 5-10 per cent from their peak, with derivatives markets predicting further declines of about 20 per cent. Price falls of this magnitude are likely to mean more than 10m would have negative equity in their homes and more than 2m foreclosures would take place over the next two years.
Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases.
What can public policy do? It cannot and should not try to fix the fact that at current prices the supply of homes significantly exceeds demand or the reality that many own homes, often for speculation, that are no longer viable and should be back on the market.
But it can and should address a crucial issue: when the current owner is able and willing to pay more than the lender can get by foreclosing on a house, it makes no sense to go through with a foreclosure. Yet because of conflicts among lenders, legal uncertainties and concerns about encouraging defaults, there are grounds for fearing that wasteful and unnecessary foreclosures will take place on a large scale, hurting families, communities, the economy and the financial system.
How can this problem be addressed? The string has pretty much been played out on hortatory policy, to limited effect. Without finding ways of writing down mortgage liabilities, new finance will do nothing for the problem group that has negative equity. Direct government intervention in mortgage markets risks creating delays, burdening taxpayers and inhibiting necessary adjustments in house prices.
The right focus is on measures that will prevent unnecessary foreclosures by facilitating more efficient settlements between homeowners and their creditors. Legal changes currently being debated, to bring practice with respect to family homes into conformity with general bankruptcy practice in two areas, could make an important contribution.
First, remarkably, bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes.
Critics worry that such measures will dry up the supply of mortgage credit. This is a legitimate concern and the reason why legislation should be carefully and narrowly drafted, to be applicable only to past mortgages where there has been no fraud and where foreclosure is otherwise imminent. But it is worth noting that: some inhibition on lending to those who seem likely to go bankrupt might be a good thing; also, there has been an adequate supply of capital and ability to securitise in the market for vacation and rental housing, where debtors are protected; and moreover, chapter 12 of the bankruptcy code enacted in the mid-1980s, which applied these principles to family farms, helped to resolve great financial distress without long-term costs in terms of reduced farm lending – despite protestations much like those that are heard today.
Second, methods need to be found to enable creditors who accept a writedown in the value of their claims to retain an interest in the future appreciation of the homes on which they have mortgages. This is standard practice in situations of corporate distress, where debt claims are partially replaced by equity claims.
Obstacles to such mortgages include uncertainties about tax and accounting rules. But at a time when there are great advantages to inducing lenders to let families to remain in their homes – and when families facing foreclosure are prepared to do things they might not do in ordinary times – it would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs.
Bankruptcy reform alone could, on some estimates, avert 500,000 foreclosures and, by establishing templates for renegotiation, aid a wider restructuring of mortgage debts. Proper support for voluntary restructurings involving interests in future appreciation should realise still greater benefits. As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans.
The writer is Charles W. Eliot university professor at Harvard
Top economists debate Martin Wolf’s and Lawrence Summers’ columns in the FT’s Economists’ Forum
Stephen Cecchetti: Larry Summers is on very solid ground in advocating changes in the home foreclosure procedures. Not only does repossessing a home impose unnecessary costs on the people directly involved, it also creates the risk of a fire sale that will drive down prices of homes nearby. We need to find a way to mitigate these enormous costs to individuals and society.
But the most intriguing part of Larry’s column, and the one that really got me thinking, is the suggestion that restructuring of defaulted mortgages allow for the possibility of the lender taking equity in home. Not only does this allow people to stay in their homes, it also would seem to blunt the 2005 changes to the US bankruptcy code that made it more difficult for individuals to escape debts (what is known as Chapter 7). This would be great if it could work. Could it?
To see, let’s start by asking why we haven’t seen this innovation already. We’ve seen virtually every other kind of financial innovation, why not one where a home buyer can chose between a mortgage and having what would in effect be a real estate investment trust purchase a share of the home and become an equity holder?
I would love to see this sort of contract out there. It is the sort of thing Bob Shiller has been advocating for nearly 20 years. If it came to pass, we would see assets backed by pools of home equity in residential homes. These things would allow me, sitting here in Lexington Massachusetts, to own a share of my own home directly and then, by purchasing shares of the home-equity securities I would share in the gains and losses in home values outside my area.
Why don’t we see these assets backed by home-equity pools? My guess is that it is because of the moral hazard faced by the investor/co-owner means that these securities are not really viable. There is no simple, no low-cost mechanism for insuring that the person living in the home, who is a part owner, does a good job maintaining the value of the home. As a part owner who receives only a share of the appreciation or depreciation of the home’s value, there is little incentive to do a good job of painting, cleaning, and the like. And who pays for repairs?
This brings us back to Larry Summers’s idea that foreclosure proceedings include the option of replacing the mortgagee’s debt claims with partial equity claims. It’s a great idea,, but the devil will be in the details, and that means handing it over to the lawyers. I wish I could be more optimistic.
Posted by: Stephen Cecchetti | February 26th, 2008 at 3:04 am | Report this commentWillem Buiter: Larry notes correctly that foreclosures, like any form of bankruptcy, are socially costly as well as privately painful: they waste real resources. Many of his proposals for bankruptcy reform make excellent sense. Where I take issue with Larry, and reproach him for not dealing with one of the fundamental causes of the problem of excessive and unnecessary foreclosures, is when he jumps straight from falling house price to negative equity and then to defaults and foreclosures.
Default on a loan, including a home loan, occurs when the debtor is unable or unwilling to meet his debt service obligations. It need not occur, and in a world with a sensible personal bankruptcy law would not occur, simply because the value of one’s debt exceeds the value of the collateral the debt has been secured against – because there is negative equity.
Surely a fair number of the rising number of defaults and foreclosures are ‘discretionary’ defaults? The unemployment rate still stands only at 4.9 percent, so there have not been too many unexpected interruptions in normal earnings flows for many borrowers. The borrower has the means (labour income, other financial or real assets that can be realised, reductions in consumer spending) to service the debt, but as the value of the house (the collateral) is now less than the value of the debt he owes the bank, it is privately rational to default if there are no further substantive private costs to the borrower associated with default and personal bankruptcy.
The thrust of virtually all legislation since the middle of the 19th century has been to lower the cost of default and personal bankruptcy to household borrowers, thus raising the risk of discretionary default whenever negative equity exists. Private penalties, like exclusion of a past defaulter from future access to credit, have likewise become steadily weaker. Subprime mortgages would not exist in a world where a history with any credit impairment in it precluded one from future borrowing. Credit cards were being offered during the pre-August 2007 credit boom in the US and in the UK to persons who were known to have defaulted on credit card debt in the quite recent past.
Few American borrowers any longer seem familiar with the ‘Micawber Principle’, based on Wilkins Micawber’s observation: “Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
I would not recommend a return to Victorian-style debtors prisons or their American equivalents. For starters, the ability to service your debt is not enhanced (for most people) by being locked up. The US greatly reduced, but did not eliminate, imprisonment for debt at the federal level in 1833 (well before the UK, which followed suit in 1869, except for those who refused to pay their debts even though they had the means; these miscreants could still be locked up for 6 weeks). However, one can still get incarcerated in the US today for debts of fraud, child support, alimony and a few other categories. Not, however, for housing debt in excess of the realised value of the collateral, for credit card debt and for other unsecured debt. I propose that thought be given to an automatic lien on all the discretionary assets (e.g. second car everywhere in the US; all cars for residents of cities with reasonable public transport; TVs etc.) of a mortgage borrower and on a fraction (to be determined) of his or her income above some appropriate threshold level (to be determined). These resources would be drawn upon in case of negative equity to service the unpaid portion of the debt. It would certainly help discourage excessive borrowing.
Increasing the penalty for default will result in fewer loans, fewer defaults and fewer privately and socially costly repossessions.
It would also be helpful to increase the private cost to the lender of reckless lending, that is, lending that is too likely to result in default by the borrower. Martin Wolf has written on a number of occasions about the need to change the incentives in the financial sector to discourage reckless lending. These incentives have to be better aligned throughout the credit process, starting with the originator and progressing through the mortgage lender, the securitiser, the off-balance sheet vehicles where the securitised mortgage debt is parked etc. It would also help to have regulators that are not asleep on the job, as they must have been in the US mortgage market since 2003.
Posted by: Willem Buiter | February 27th, 2008 at 6:16 pm | Report this commentMartin Wolf: Steve Cecchetti and Willem Buiter have both made powerful points, with which I largely agree. Let me just focus on Steve’s point about equity contracts. I am sure that the difficulty of monitoring the resident owner is a reason why such contracts do not exist. But, then, the difficulty of monitoring the decisions of a corporate manager with an insignificant stake in a company whose shares one owns is not, it seems to me, fundamentally different. Is the ability for outside investors to monitor behaviour really so very different in the latter case?
Posted by: Martin Wolf | February 27th, 2008 at 7:49 pm | Report this commentEdward J. Dodson (guest): Once again, we are as a society debating what public policy measures are appropriate to mitigate the negative consequences of other public policies. In this case, the policies are those that create expectations of huge gains out of investment in or ownership of residential real estate.
Economists could play a much more constructive role by describing the market forces at play with greater specificity. I say this as someone who has spent decades trying to put together affordable housing initiatives that would counter the effects of contradictory existing public policies. I have found in my discussions with bank economists, for example, that too few possess a good understanding of the operation of land markets, even though land markets impose heavy costs on those who produce goods and services, including housing.
The irony is that land markets are not that difficult to understand. With rare exceptions (e.g., buildings having some historic character) housing does not increase in market value. A house must be constantly maintained and its main systems actually replaced to match the resale value of new construction.
The component of ‘housing’ that is subject to speculation is land. A major reason for the periodic escalation in mortgage loan defaults and foreclosures is that the GSEs and FHA have consistently increased mortgage loan limits to accommodate rising land prices. When combined with lower down payment requirements, more flexible creditworthiness standards and a stable or declining interest rate environment, a higher percentage of mortgagors are certain to be vulnerable to even modest shocks to their personal financial circumstances.
If economists want to help solve the problem of widespread mortgage foreclosures, my suggestion is that you get behind policies that will tame land markets — starting with restructuring of the property tax so that property improvements are eventually exempted and land values are more fully captured as a primary source of public revenue.
Mr Dodson retired in 2005 from Fannie Mae, where he was a senior business manager in the Housing & Community Development group based in Philadelphia, Pa. He is a graduate of Shippensburg and Temple Universities in Pennsylvania.
Posted by: Edward J. Dodson | March 3rd, 2008 at 5:20 pm | Report this commentMartin Wolf: I very much liked Mr Dodson’s comment here. It parallels arguments I have been making for some time for shifting to land-value taxation in the UK, where the combination of tight planning controls with modest taxation of land, has generated enormous appreciations in the price of land. My very rough estimate is that the real price of land has risen something like four-fold in London over the past decade. Quite apart from the economic effects, this has generated a massive intergenerational shift in wealth, from the young to the old, which I regard as highly undesirable.
Posted by: Martin Wolf | March 3rd, 2008 at 6:22 pm | Report this commentSolutions to the liquidity risk crisis and general panic may be of several kinds of which a concerted effort to plug all holes in the dyke comprehensively is probably the least likely. There is a food chain hierarchy of knock-on effects. Intervention can be made at the top or the bottom of the food chain. The Japanese authorities responded to the bankruptcy of retail banks (when property and construction bubbles burst in the ’90s) by pumping money into the top end, into the ‘city’ banks that in turn guaranteed the retail banks. Something similar is being attempted piecemeal now by central banks in USA and Europe, but the financial system to be supported in this way is far more complex and more global and the issues involved more profound, ranging from the political ideological to whether credit boom economies will be allowed again and dramnatic shifts in world trade. A more effective approach for Japan might have been to shore up retail banks directly and to revive the Construction sector (20% of GDP) whose bursting bubble led to dramatic bubble and burst of property prices.
This is roughly what is proposed in seeking to minimise the impact of foreclosures on families and small businesses in the USA, and may be the most effective solution by acting at the bottom of the food-chain. The financial world is in a panic over recession and borrower defaults (delinquency rates). The prospect of recession suggests rates will worsen and turn into a higher % of economic losses. But, past experience tells us that over the medium term, the period to recovery, actual losses will reflect the rating agencies ‘through-the-cycle’ risk ratings. The crisis by marking to market has exposed the fact that many investors and financial institutions borrowed short term (some leveraging at very high multiples), to buy long term financial assets and now cannot re-finance. The crisis exposes the multipliers in the knock-on effects in the financial system. Therefore, by securing the defaulting borrowers at the bottom rung of the crisis, a much larger benefit should multiply up throughout the system. Extremely over-leveraged and poorly diversified institutions will remain discredited and will close. But they may fail with less collateral damage.
We must accept bubble-burst recessions as necessary, and therefore desirable, to mitigate one-way markets. What happens in a recession, roughly, is that a quarter of the population with net assets in the good times now has zero net assets. Another quarter that had assets, but zero net assets, now becomes net indebted. The poorest quarter has no assets and never has any. The richest quarter remains in surplus assets and funds and can buy a significantly bigger share of all assets in the recession. To support US borrowers in trouble will mean supporting about 50 million people and 10% of all businesses. At an approximate cost of $2-3 trillions this could be financed within the amount of non-marketable Federal Debt bonds (vested in Social Security Funds), by issuing that paper to the banks in exchange for the banks asset backed securities (mortgage-backed etc.) Technically, this would be the least painful, smoothest approach. The financial system would gain a lot more government bonds to shore up quality of balance sheets, and government, as owner of $2-3 trillion of retail banking assdets, can instruct banks to provide delinquent borrowers with a softer landing i.e. “go slow and easy on foreclosures.”
There is a foreign dimension, which is that securitised products were sold to foreign, mainly Asian, investors, who have yet to publish their mark-to-market losses. Selling financial assets finances trade deficits. The credit crisis is therefore changing the shape of world trade dramatically. This may be a good thing if the adjustment is not too su8dden, too shocking. Foreign investors will no doubt be delighted to swap their asset backed bonds for US Federal debt, or at least to have the convertible option to do so.
Then, that settled, recovery may seem a more certain medium term prospect.
Robert McDowell
Posted by: Robert McDowell, Edinburgh | March 28th, 2008 at 8:07 am | Report this comment