Here is a great piece from Anthony Sanders at ASU’s W. P. Carey School of Business. Here are my comments on the article.
The Real Cause of the Economy’s Problem
“The underlying core of the economy’s problem is that the housing and mortgage market is still collapsing at record speeds,” he said in a December speech before the Dean’s Council of 100, an advisory group at the W. P. Carey School of Business.
Both federal regulators and private lenders have tried tinkering with the mortgage market via proposals to reset the loans of struggling borrowers. The trouble is, their methods — freezing interest rates on adjustable-rate loans and extending mortgage lengths — have made little difference. Most borrowers who’ve received these sorts of loan modifications have ended up defaulting anyway, Sanders pointed out. In fact, modified borrowers are re-defaulting at rates of between 50 and 60 percent.
Instead, would-be mortgage doctors need to focus their efforts on the real cause of virus — disappearing equity. With house prices falling fast, more and more people are “upside down” on their mortgages, owing more than the market value of their homes. Any attempt to restructure these loans without adjusting the principal won’t bring the market back into balance, Sanders said.
People come up with a lot of wrong explanations for the financial crisis. In reality, the root cause is falling home prices. It wasn’t a credit crisis or liquidity crisis. It was a solvency crisis. Falling real asset values made lenders skiddish about lending to companies that were possibly insolvent.
Banks: Dumber Than a Box of Builders
Laws in two of the states hit hardest by the crisis — Arizona and California — limit the ability of lenders to sue foreclosed borrowers to force them to pay the difference between the proceeds from the sale of their residence and their debt. “If you throw your keys to the lender, they can’t touch you,” Sanders explained. “They can ruin your credit — but there’s no credit out there anyway. You can just walk away with no real consequences. Plus, in four years, your default disappears from your credit rating.”
In a foreclosure, a lender often loses some of the money that it lent and faces hefty administrative hassles. In fact, loss severity on defaulted loans can run 50-60 percent of the loan balance. The lender ends up with a house that it can sell, but that’s the last thing that lenders and investors want, Sanders said. (Many loans are converted into mortgage-backed securities and sold to investors like pension funds.) Foreclosure is complicated and costly, and a seized house typically won’t fetch top dollar because delinquent borrowers often stop tending their properties.
Foreclosure, in other words, is a fool’s game; everybody loses. The borrower loses his home and mars his credit, and the lender incurs costs to seize and sell the house.
This whole “How can banks be so stupid” discussion is common among Realtors.
I keep thinking lenders will eventually adapt their massive bureaucracy to the new reality but so far they have been as dumb as the home builders.
Banks Don’t Do Math
Sanders argued that a better outcome for all would be reducing the principal amount of mortgages like these so that borrowers can remain in their homes and continue to pay off their loans, even if at a reduced rate….
The federal government thus should encourage lenders and investors to write off part of the value of troubled mortgages, he said — that is, it should persuade them to reduce principal amounts to reflect slumping real estate values. Lenders and investors would then have to take losses on their books, but they wouldn’t lose as much money as they would in foreclosures. “Twenty percent write-downs trump 50 to 60 percent losses,” he noted. Sanders called his proposal a “voluntary private market solution.”
Sanders makes some good suggestions.
Ditching the Principal
I highlighted in the quote below, an idea that is totally new to me.
In a November testimony before a congressional committee, Sanders suggested that principal adjustments could take a variety of forms. A lender might just cut the amount and be done. Or it could reduce it, but the government would then require the borrower to pay capital gains tax on the amount of the reduction when the house sold. That way, the government would recoup some of the cost of its wide-ranging effort to stabilize financial markets.
A lender might also enter into shared-appreciation mortgage with its borrower: it would grant a principal reduction in exchange for a share of the future appreciation when the house sold. Or a lender might allow a borrower to reduce the principal gradually, granting a small cut with each subsequent mortgage payment. That would encourage people to keep making timely payments.
I don’t love that idea but I love that new ideas are being thought through.
Wrong Way Write-Downs
I suspect, without evidence, that banks are afraid to do write-downs of principal because of the possible contagion effect.
When the Feds bailed out the banking industry, we saw how many other industries wanted their bailout too.
What would happen if banks started to bailout some home owners by cutting principal? Every homeowner who was under water would want one, it’s only fair. How do you stop that small pox from killing the banking industry?
At least if the family loses ownership and is kicked out of the home, it increases the costs to the family of not making payments and that would tend to lower defaults.
If, however, when you stop making payments, you are NOT kicked out of your home and you are instead given a huge cut in your principal, then it would be rational for everyone with negative equity to simply quit making their mortgage payments, even if they were able to make the payments.
That’s the doomsday scenario for the banking system.
There would be no cost to not making your mortgage payments. In fact, you would be richly rewarded for not making your mortgage payments.