Via Mark Thoma, the frighteningly thorough dragnet of the econoblogosphere, I found an excellent short piece by Richard Green on "cram-downs", the solution to the subprime crisis favored by Ben Bernanke, and a number of left-leaning commentators. "Make the lenders eat the damage done by their loans" is a philosophy that is not without its appeal--which is why Hillary Clinton has been flogging her five-year rate freeze on the campaign trail. But the Law of Unintended Consequences dictates that things usually aren't so easy, as Mr. Green points out:
But two serious problems stand out. First, future investors could respond by requiring higher spreads for mortgages. If these spreads get capitalized into values, the borrowers whose loans got crammed down could find themselves under water again, and the problem will remain.Second, there is an issue of fairness. Consider two borrowers, one of whom has a 20 percent down payment, and the second of whom has a 5 percent down payment. If house prices decline by 10 percent, the second borrower gets debt forgiveness, while the first one doesn't. Perhaps the first casualty of financial crises is fairness, but as a policy matter, it is hard to ignore the problem.
The fairness issue is not insurmountable--irresponsible homeowners get hurt almost as badly as irresponsible ones if foreclosures flood their neighborhood. But the first point is killer. It may be economically irrational, but people do not calculate the price they are willing to pay based on how much the house is worth to them; they calculate it by how much mortgage they can afford on their monthly salary. Having the government abrogate legal contracts, whether by freezing interest rates, forcing lenders to write down the value of the loans, or another means, will make them much less willing to lend in the future. Indeed, some of them will be less willing to lend because they will be bankrupt. If the supply of credit contracts, the price of credit--i.e., the interest rate--will rise. And if interest rates rise, the price of housing will fall still further, because at higher interest rates, buyers can only afford to take out a smaller loan. That will put many buyers, including the subprime ones, deeper under water. The cure seems worse than the disease.
To understand what has happened with the mortgage disaster that we have, one must know the history.
Unfortunately, there are no investigative reporters or reliable news people left anymore.
I lived through this history and I remember it.
I know that none of your readers will listen to me, so I will not waste my breath.
Just let it suffice to say that I saw this coming at least 10 years ago. Anyone who is surprised should make history a more important part of their life.
I would think that a lot of people consider housing an expense, not an investment. A house isn't an asset unless it's bringing in money. If you're currently living in it, it's just sitting there and costing you mortgage, property tax, utilities, and maintenance. It's only when you try to sell it that it's worth anything. (I suspect that might have something to do with why people make their calculation based on ability to pay rather than worth).
But suppose housing prices fall, and wages stay approximately the same. Because people calculate based on ability to pay the mortgage, more people would be willing to buy houses, wouldn't they? So more people would buy housing, less houses are on the market, and values would start going back up.
I may be slow today... but what's the downside for a non-struggling homeowner (say, me) who's not anywhere close to upside-down to use this opportunity to reduce the cost of his mortgage and the monthly payments? As far as I can tell, this program would let me exchange 20% percent of my (let's say 30 yr fixed @ 6% APR) mortgage for a very cheap (Treasury + 0!) 15-year ARM with immediate reduction in payments. Wouldn't that lead to a massive over-use of the program?
I am even slower than I thought... posted into a wrong thread. Sorry :(
I would think that a lot of people consider housing an expense, not an investment.
Well, I know a lot of people who tend to think of it the other way (not me, and not my folks, either. They paid off their house and plan to stick with it). Some of them are smart enough to time their purchases and sales with long-term growth trends, some of them not so much.
Unfortunately, the housing bubble helped accellerate the investment perspective among a middle class that previously would have tended more towards an expense-based perspective, hence the rise of the serial house flipper, some of whom reinvested the gains in a series of progressively more expensive houses and didn't get out of the market in time, and are about to discover what the Greater Fool Theory is.
Fairness in housing doesn't exist in Santa Barbara, Calif., where I live. Most here seems to believe in the delusion of "affordable housing" where politicians gleefully attend ribbon-cutting ceremonies for housing units reserved for either lower income people or for government workers. These units are typically allocated by lottery. The upshot is that someone earning less money gets to live in nice, new housing for less than someone who earns a bit more money pays for some free-market apartment built in 1966.
Another aspect of the lack of fairness problem in forcing mortgage lenders to bear the burden of their bad lending practices is that this approach ignores the role government played in creating the current situation. Government is not neutral with regard to home ownership. It has created incentives (tax and otherwise) to encourage home ownership. It has interfered in the lending markets, prohibiting red lining and other practices it found discriminatory. It created a pseudo-government agency to buy up mortgage debt, increasing the amount of capital available to lend several fold. It blackmailed banks into lending to poor credit risks by insisting on "community investing" programs in exchange for regulatory approval of mergers and other legitimate business transactions.
This combination of governmental incentives, programs, actions, and inactions artificially inflated home values and increased risky lending practices. It's a bit rich for government to ignore it's role in creating this mess when crafting a solution. That won't prevent it from happening, but it's a bit rich.
David Walser @ March 7, 2008 2:52PM:
While the gov't surely provides tax incentives for housing, it doesn't force anyone to actually buy a house. Also, while the gov't required banks to offer credit to those underserved folks living in cities in exchange for the allowance of merges, it didn't force banks to accept that trade off.
I just don't see those two gov't actions as forcing anyone into lending to people who clearly couldn't afford it. Both the greedy banks and greedy people are at fault here. But, I'm not sure the gov't really did what you say they did.
No.
To the extent that mortgages are foreclosed, the lenders will bear the cost of the difference between the outstanding loan amount and the resale price of the house, plus the costs of preparing the house for sale. The previous owners will lose their equity, which is generally limited.
There are no innocents on this issue, but there are no devils either. If the buyers did not understand the risks involved in the transactions they were entering into, they were not paying very much attention to the proceedings.
There is no "Get out of Jail Free" card in real life. If the "guilty" avoid the pain, it will merely be distributed to the rest of us.
Should mortgage lenders bear the brunt of subprime pain?
Of course they should. They have lots fewer votes than the people who want a freebie.
Having the government abrogate legal contracts, whether by freezing interest rates, forcing lenders to write down the value of the loans, or another means, will make them much less willing to lend in the future.
No matter what the government does, the lenders are going to be much less willing to lend in the future. And a good thing, too-- they made terrible loans based on not enough collateral.
Take this situation: A person buys a house for $500K, getting 100% financing with a liar loan. Now the house is only worth $300K, and the buyer can't afford the payments.
Megan says that the government shouldn't cram down the loan, because then the bank would be screwed. But the bank is already screwed; it has $300K collateral on a $500K loan.
Better to say, OK, the buyer now owes only $300K, and the appreciation of the house, if any, is shared in some specified way between the bank and the buyer. If home prices skyrocketed, the bank would be worse off, but home prices aren't going to skyrocket, so the bank is better off not having to foreclose and try to sell the house.
Whatever policies ultimately are chosen, I hope that they are based on an analysis of real data, including such items as
1. what % of sub-prime loans went for homes below/at/above the local median housing price
2. what % of underwater borrowers are underwater with respect to their home's original selling price?
3. what % of troubled mortgages are for homes where buyers have refinanced and taken significant equity out of their homes (relates to #2)
4. what % troubled loans are for owner occupied homes
etc. etc.
I've looked but have not been able to find this information. The proposals that I have read don't contain this data.
I have a very hard time understanding why the Federal Government should bail out borrowers who have taken out 2nd mortgages and home equity loans for greater than the amount of their original down payment and subsequent principal payments. I have no clue what % of borrowers fit this profile and without the type of missing information I indicated above, I don't understand how anyone can devise a reasonable policy.
There is a narrow band of cases in which a "freeze" is a win-win situation for lenders and borrowers.
Banks have other options than forclosure. There are circumstances where they see more profit in renegotiating a loan than in forclosing. Another common practice is the short sale, where the ownwer sells to the bank rather than forclosing. The bank loses less money than it would forclosing, and the seller parts with some money to avoid having a forclosure on their record.
Right now, a lot of debt is owed not to banks, but to holders of securitized mortgages. They don't have any flexibility. It's pay or foreclose. While there could be market inovations to broker deals between owners facing forclosure and holders of securitized debt, they don't exist right now. It could very well be in the lender's interest to accept short term losses until the market can respond to the current situation. If an ARM moritorium of a year or so was set, with a "catch-up" clause, it would allow borrowers and lenders time to reach mutually beneficial agreements that would otherwise be missed.
How's this: offer a uniform debt-equity swap for all borrowers in same housing market, whether underwater or not.
Say home prices have declined 20% in your local Case-Shiller zone or ZIP. Offer everyone in that market this option:
Principal written down by (20+E)% but in exchange, when you go to sell the house, you give lender (say) 50% of any capital gain over (Original Appraisal * .8)
While not perfect, this seems to hit a good compromise between incentives, loss-and-foreclosure mitigation, and fairness.
So I guess we can put the chairman of the Fed into the "left-leaning" column...
The reality is that mortgage lenders have already been "crammed down" on a big % of their mortgages. They just haven't booked the cram down yet. And Bernanke's point (and I believe it was more theoretical than anything) is that if you reduce the balance by some percentage, lets say 20%, this reduces the odds that you'll have to foreclose. And foreclosure is way more expensive than losing 20%.
Making a "cram-down" part of PERSONAL bankruptcy will just take away one of the few elements that has kept mortgage debt cheap compared to other types of consumer debt.
Look for bigger downpayments baby! Ever notice you can't buy a new car without a healthy trade-in or money down? No, a cramdown is a whacky idea. Debt for equity swaps at least create good incentives though god knows who'd enforce these contracts (there are no national real estate laws)
And, no, Bernanke is not exactly left-leaning, he's just a naive academic, so he just seems left-leaning.
Martin Feldstein's proposal in Friday's WSJ might be the most reasonable one I've heard so far on ameliorating the mortgage mess: "How to Stop the Mortgage Crisis".
Ignore that last comment; I just saw that Megan already posted about Feldstein's op/ed.
Re: Right now, a lot of debt is owed not to banks, but to holders of securitized mortgages. They don't have any flexibility. It's pay or foreclose.
This is not necessatily true (at least not from a legal standpoint). The trust in which the securities are held has full authority to renegotiate, or to empower the mortgage servicer to do so. What usually happens though is that the investment bank which created the security will buy back the problem-ridden mortgages and determine whether the loan can be saved or not, allowing the servicer to renegotiate if the decision is made that the mortgage can be saved under new terms.
What are your thoughts on the following suggestion: Encourage lenders/borrowers to extend their mortgage terms (by either 50% or 100%) such that a 15 year mortgage would become a 22.5 or a 30 year mortgage. This would lower the payments, without forgiving either side. And, when liquidity returns, the borrower could refinance to a shorter term if possible.
Thoughts?
Good grief! Let’s just be honest and propose that the government pay the mortgages for those in default. Strip away all the verbiage, and these proposals boil down to just that- socializing the losses incurred by imprudent people.
The fairness issue is not insurmountable--irresponsible homeowners get hurt almost as badly as irresponsible ones if foreclosures flood their neighborhood.
Do you not proofread your stuff at all, Megan? You make this sort of error far too often for someone who would have us believe she is a professional writer.
Even though his interrogatory is a bit ambiguous, spencer has a point. I have noted the same kinds of errors in her writing- errors that should be readily caught by just a casual proofreading.
Nice catch, spencer, and thanks for the contribution to the discussion. Boy we sure are lucky to have you.