Friday, June 25, 2010

Konczal on Mortgages

I had hoped to write an angry post in response to Mike Konczal’s latest missives on mortgages; but his pieces are far too reasonable and well-done. Instead, I’ll agree with many of his points and make some hay over small differences.

The way I think about mortgage debt generally is through an Irving Fisher perspective. Prices for assets and goods are determined in competitive markets, and so can fluctuate over a business cycle. Contracts like debt, on the other hand, remain fixed in nominal terms. This causes huge problems in a real estate slump combined with recession, as you see more households struggling to make payments on now-unprofitable properties.

You can see that in this Federal Reserve report. Household net worth plunged in this recession, led by large drops in real estate assets. But household real estate liabilities—their debt burden—remained relatively constant.

That’s where the push for modifications, for Right to Rent, for cramdown, etc. comes from—an attempt to lower the principal balance on homes so that housing stays a reasonable bets for owners, rather than albatrosses holding down spending and consumption.

Modifications

I think the best way to make this happen would be if mortgage servicers got on the phone with delinquent borrowers and wrote down seriously underwater homes to a level that would induce people to keep making payments. Servicers should have a great deal of interest in cutting these deals; these types of haircuts happen all of the time for other types of debt; and they used to happen for mortgages as well.

But there are variety of reasons this isn’t happening now, or at least aren’t happening effectively. Banks are reluctant to expose real estate losses, because that would force them to realize accounting losses on their balance sheets. One suspects that many American banks are insolvent and are trying as hard as possible to avoid exposing that issue. Other problems include coordination problems with securitized loans. The act of chopping up a loan, combining it with others, and selling it as a security makes it much harder to monitor the original loan and come up with a deal if necessary. Then there is Fannie and Freddie’s inability to properly use HAMP, which makes no sense.

Banks really have no business harassing “strategic” borrowers given the cynical attitude they hold towards going bankrupt if necessary, and lapping up federal funds if possible. The real estate mess is their own fault for not negotiating win-win deals with customers who have problems, which is something they are perfectly willing to do for corporate clients.

Cramdown
For these reasons, I’m becoming more willing to look at Konczal’s preferred solution of a cramdown—allowing judges in bankruptcy courts to write down the principal on homes themselves if someone files for a Chapter 13 plan. I still find this a less appealing option than giving servicers the proper incentives to do it on their own, but we’ve seen how well that strategy has worked.

There are a couple of problems with this approach that Konzcal skips over, and a couple of ways to fix them. One big problem is that the vast majority of Chapter 13 plans fail, and we don’t have a good sense of why this is. Cramdown in bankruptcy would only apply for people who fully complete their bankruptcy plan, so this fix would just kick the problem down the road for most people. I suppose you could argue that the reason bankruptcy plans fail is because the home wasn’t written down enough; but it seems more likely that people become unemployed/lose income, and are using bankruptcy purely as a delaying tactic.

Then there are the problems that changing the bankruptcy code would have on the willingness of people to file for bankruptcy, and the willingness of banks to extend future credit. The more we make mortgages disposable, the more expensive it will be to get a mortgage. Of course, that will have the positive effect of reducing the number of risky borrowers. But it will also raise the pressure to get the government more heavily involved in mortgage lending, and force even safe borrowers to pony up more monthly income to rent payments. As Konzcal never tires of telling us, the steady rise of payments going to service secured debt eats away at disposable income.

A good way to fix these problems would be to make cramdown retroactive—only available, say, to mortgages purchased before 2008. We could even think about tying cramdown rules to zip code level price changes to reduce judicial discretion—though one suspects judges already apply fairly simple and consistent rules.

Costs of Default
But I want to push against two ideas—that the concern over strategic default is entirely unwarranted, and that subprime mortgages are a horrible deal. The problem is that mortgages come embedded with the “option” of default, since you can walk away at any time, usually without legal recourse (though, of course, your credit score will take a hit).

Homeowners in the past have exercised this option sparingly, as they want to stay in their homes, and because of social norms which argue against mortgage default. Indeed, banks relied heavily on these norms as they rolled out an unprecedented expansion in home mortgages and home equity lines of credit. These norms are shifting as delinquencies and foreclosures skyrocket. We have some evidence now that mortgage default gaining popularity relative to credit card default. For an individual borrower, looking at your home through a pure profit-loss perspective is the way to go. But when everyone starts doing this, that induces more and more people to walk away, which lowers prices, which makes even more people walk way. Ultimately, if mortgage debt was no more secure than credit card debt, it would be prohibitively expensive for all but a narrow minority of people. This may be an attractive world to move to, but the costs of getting there in the middle of a housing bust would be large.

Then, there’s the issue of how to think about subprime borrowers who took out these loans and are now suffering. Again—I think the right way to think about them is to realize that these borrowers bought a product with an embedded option. They had the ability to walk away if things ever went south for them—and, in many cases, they are now exercising that exit option.
I think this better fits a story of predatory borrowing, rather than predatory lending. Remember that it’s difficult to gauge the success of an investment from a purely ex post perspective. We only observe one particular economic outcome, but many other outcomes were possible when you made the investment. Had housing prices kept going up, subprime borrowers would have done very well indeed—and they did in fact do quite well for a number of boom years. Sure, they didn’t build equity—but they they pulled tons of cash out from their home to consume more than they could otherwise. That sounds like a pretty good deal to me. Allowing people to get a product with great upside and limited downside sounds like a far worse deal for the banks doing the lending than for the people buying the product.

This is also why I'm much more excited about FHA's threat to deny mortgage insurance to strategic defaulters. Ideally, I would like FHA to deny mortgage insurance to anyone who has gone delinquent on a mortgage in the past. I'm skeptical of the idea that the GSEs were the "cause" of the real estate meltdown, but they are clearly sinking ships, and any attempt to raise their underwriting standards would be welcome.

What Next
I want to go a little further than Konczal and argue that our failure to deal with debt generally is an issue. America’s debt-to-GDP is around 300%. These aren't the catastrophic levels of Iceland or even England, but is a serious issue. Replacing private debt with public debt doesn't entirely deal with this issue either. We need serious attempts--default, bankruptcy, or inflation--to erode the value of debt contracts; and then tax reform or regulations to limit the system-wide desire to take on additional debt. I used to be skeptical of this idea, but debt-fueled growth really is not sustainable, and destroys an economy's resilience.

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