Drowning or waiving
Oct 21st 2010
From The Economist print edition
The policy options for alleviating America’s huge negative-equity problem
AMERICA’S south-west may be a very dry place but nowhere else in the country are more homeowners “under water”, owing more on their mortgages than their homes are worth. In cities like Phoenix and Las Vegas prices have fallen by up to 50% from their peak; more than half the mortgages in Arizona and Nevada are in negative equity (see map). Yet the problem is national. One in four American borrowers are under water. Over 4m households owe at least twice as much as their home is worth.
Such inundations have nasty effects. Homeowners that are reluctant to default but unable to sell at a loss are left stuck where they are. This throws sand in the gears of America’s famously fluid labour market. A recent IMF paper attributes 0.5 to 1.25 percentage points of America’s unemployment rate to this factor. Defaults may be an even bigger problem. Job losses will often push underwater borrowers into default since a sale isn’t a realistic option. And as the crisis has dragged on, more Americans have defaulted voluntarily. Estimates from 2009 suggest that 26% of defaults were “strategic” in nature; where equity has fallen below 50% of the loan’s value, around half of defaults are strategic.
The resulting foreclosures cause lots of damage. Underwater borrowers who sell their home typically get a price 13% below the mortgage value. When homes are foreclosed upon and sold by lenders, the discount rises to 35%, largely because the property is not being maintained. This steep drop in price harms other homeowners. The values of neighbouring houses are pushed down, forcing other borrowers deeper under water.
Since lenders bear the brunt of the higher losses that foreclosure entails, their general reluctance to modify the balance of mortgage loans is puzzling. If mortgages could be written down to a value above the likely foreclosure sale price, that would generate benefits for both creditor and borrower. Yet a report earlier this year into the government’s foreclosure-prevention programme showed that principal was forgiven in only 2% of cases. So what is preventing a better outcome?
Loan servicers, which manage loans on behalf of investors in mortgage-backed securities, may fear lawsuits alleging that borrowers have been treated too generously. Writing down loan values often affects more than one lender—second, third and even fourth mortgages were common during the housing boom. Banks are wary of moral hazard: if word spreads, borrowers with the ability to pay their mortgage may deliberately miss payments in order to get their loans adjusted.
This last problem can be addressed by changing borrowers’ incentives to default. Contingent write-downs are one example: loans would be written down in increments over three years, but only if the borrower stayed current on payments. Another is a “shared appreciation” scheme in which principal reductions are combined with an equity stake for lenders. Equity gains from subsequent price increases would be split between homeowners and lenders upon sale of the home.
Whether such ideas would prompt many more write-downs is unclear. They do not address the problem of multiple claims on the same underlying assets, for instance: that would probably require banks holding junior liens to take a more realistic view of their value and write them down. They also bump up against the complexities of modifying securitised loans. John Geanakoplos, an economist at Yale, proposes that this problem be addressed by adopting legislation that strips the responsibility for modifications from servicers and hands it to “blind” government-appointed trustees who would make decisions without knowledge of the loans’ status. Mr Geanakoplos reckons this would address the incentive problems and legal issues faced by servicers, which often have fiduciary duties to holders of mortgage securities.
A measure called lien-stripping, or, more commonly, “cramdown”, offers another way around the securitisation bottleneck. This would tweak the existing bankruptcy provision known as Chapter 13 to allow judges to write down the value of a primary mortgage. Cramdown is already allowed for other forms of consumer debt, such as mortgages on holiday homes. Research examining the impact of cramdown on agricultural loans found that banks usually got more than foreclosure value on reorganised loans, and that interest rates scarcely rose. At the same time the possibility of a principal write-down in bankruptcy made banks more willing to negotiate reductions pre-emptively.
Submerged acquisitions
Eric Posner and Luigi Zingales of the University of Chicago have proposed a plan whereby an underwater homeowner living in a postcode area which has suffered a certain level of price decline gets the right to approach a judge and begin negotiating a write-down. The pain of bankruptcy should deter opportunists; judges would foreclose on those who cannot afford even a smaller mortgage. The big drawback is that this would damage creditors’ rights. To make the outcome fairer for lenders Messrs Posner and Zingales propose a shared-appreciation scheme.
More ambitious still is the “right to rent” programme advocated by, among others, Dean Baker of the Centre for Economic and Policy Research. Mr Baker would give defaulting borrowers the option to rent their homes at market rates. The bank would obtain the whole of the equity stake in the house; with rental income still flowing in, sale of the property could be delayed until markets were healthier. Critics point out that property management is not a core skill of banks, but the job could be outsourced.
There is another way. In the 1990s Mexico cleaned up its debt crisis by offering large government subsidies, of up to 60% of a loan’s book value, to help pay down borrowers’ debts. Such a programme would not come cheap—America has some $766 billion in negative-equity debt—but it would have the distinct advantage of simplicity. The unfortunate truth is that there are no nice options left. Large-scale voluntary write-downs look unlikely—they surely would have happened by now. That leaves a choice between twisting lenders’ arms, throwing public money at the issue, or letting the waters close over people’s heads.
Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.
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