Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

22 October 2008

Why McCain’s Foreclosure “Rescue” Won’t Work, and What Will


Introduction
Why McCain’s Plan Won’t Work
What Will Work
Conclusion

Introduction

In the second presidential debate [search for “bad home loan”], John McCain proposed a solution to our mortgage-housing crisis at the Main Street level. He wants the federal government to buy up distressed mortgages and renegotiate them with homeowners so they can stay in their homes.

Again and again, I’ve argued on this blog for addressing the mortgage housing crisis, as distinguished from the credit crisis it has caused. Yet so far our government has done absolutely nothing about the housing-foreclosure meltdown. So McCain’s proposal deserves careful analysis.

Analysis shows that his proposal would not work without imposing an enormous expense on taxpayers, paralyzing government during our economic crisis. It would also increase moral hazard by removing all market discipline from financial intermediaries, i.e., those culprits in the crisis below the level of Wall Street and the banks that Secretary Paulson is trying to rescue now. This essay explains why McCain’s proposal won’t work and what will.

Why McCain’s Plan Won’t Work

McCain has never explained at what price government would buy the mortgages. That’s a fatal omission, for price is the essence of the crisis. We have a crisis because markets cannot determine an agreeable price for mortgages that are delinquent (defaulted but not yet foreclosed) or in foreclosure.

These mortgages have no discernable market price for two reasons. First, the very fact of delinquency or foreclosure suggests that the homeowner can’t continue to make the agreed payments on the loan. So the loan is worthless and its terms are irrelevant. They can’t help determine either price or value because payments under the loan have stopped.

Second, once the loan terms are irrelevant, the only measure of price or value is that of the collateral: the home. But no one knows what home values are today. They’ve been in free fall for about a year with no end in sight. Worse yet, in neighborhoods hard hit by delinquencies and foreclosures, vacancy and resulting blight create an amplifying effect, deepening the downturn in home values. As the general economic recession deepens, this downward spiral will only worsen, especially in neighborhoods mauled by job losses and plant closings.

So no private party is willing to buy distressed mortgages at any price, because no one can determine what a fair price might be. In addition, everyone fears (with some justification) that prices and values will continue to go down. So few are willing to buy even at prices that seem “low” or “bargains” today.

That’s also why the home sale market is so stagnant. For the very same reasons that home sales are weak today, no one will buy mortgages or the securities that bundle them.

So in order for government to buy the mortgages, it will have to pay a price higher than any private party is willing to pay. In other words, it will have to take more risk of a loss than private parties (including the sophisticated folk who created this mess) are willing to take. If the government holds the toxic mortgages for the long run, the housing market may eventually turn around, allowing the government to sell them at a profit. Or the government may profit as homes appreciate and are sold and the loans are paid off (as long as the government includes appreciation-sharing clauses in its renegotiated deals with homeowners).

That sounds fine in the long run. But real estate prices take a long time to recover from a burst bubble—six years in California in the early nineties, and over a decade in Japan. In the meantime, enormous sums of taxpayer’s money will be tied up in illiquid assets, leaving nothing left over for investing in health care, energy independence, schools, roads, other infrastructure, or reducing the federal debt. McCain’s solution is thus a recipe for federal fiscal paralysis during most, if not all, of the next administration.

Moreover, McCain’s plan would drastically increase the problem of moral hazard. By relieving the private parties who created and packaged the toxic mortgages in the first place, it would immunize them from the full force of the losses that they so richly deserve. His plan is a piece with Secretary Paulson’s “Lake Woebegone” approach to bailing out banks. It gives no play to much-needed market discipline.


What Will Work

Any realistic solution to the foreclosure crisis must meet three tests. First, it must set a realistic price for distressed mortgages that has reasonable validity now, not years from now when expectations of a housing recovery may or may not be fulfilled. Second, it must act quickly before our economic collapse traps millions more homeowners in foreclosure and destroys thousands more neighborhoods. Third, it must not tie up enormous amounts of federal capital for years to come, because we need that money to (1) fight the credit-banking crisis, (2) invest in infrastructure, (3) solve our many other problems, and (4) reduce the federal debt.

John McCain’s solution fails the first and third tests. It has no price setting mechanism, and it would tie up huge sums of federal money in illiquid mortgages for years.

Barack Obama has proposed a better solution: allowing homeowners to modify the terms of their mortgages in bankruptcy. That solution would satisfy the first test: the bankruptcy court would, in effect, set the value of each mortgage (individually) based on the homeowner’s ability to pay. That solution would also satisfy the last test. It would require no federal investment at all, other than in the administrative expenses of bankruptcy courts.

However, the Obama solution would hardly act quickly. Bankruptcy proceedings are notoriously slow, and they would become much more so as millions of homeowners’ cases clogged the bankruptcy courts.

Obama’s solution also has another disadvantage. It would impose an unfair burden on the subprime prey—the people whom predatory lenders trapped in unsustainable mortgages. It would require them to seek and retain competent bankruptcy lawyers and endure the expense, tedium and suspense of bankruptcy proceedings.

What if an economically similar proposal could put the shoe on the other foot, requiring the predators and their successors, not the prey, to initiate and conduct litigation? There is such a solution, and here’s how it would work.

Congress could pass a new law allowing federal authorities to condemn (confiscate) any distressed mortgage at a price specified by a formula. For homeowners who still have income, the formula price would be what I call the “prudent value”—the present value of thirty years’ worth of level monthly payments at one-third the homeowner’s gross monthly income. (That’s the highest actual payment most prudent lenders would allow before all the subprime silliness started.)

The new law would allow the government to condemn and acquire any distressed mortgage and the related loan in exchange for this prudent price. Then it would revise their terms to allow the lender to recover, on any later sale of the home at a profit, a retroactive 10% down payment (based on the prudent price), plus 50% of any additional price appreciation.

For reasons explained in an earlier post, this plan would clear the toxic-asset logjam quickly. As soon as the government had revised its terms, each mortgage would be worth more than the government had paid for it, due to the retroactive down payment and the appreciation sharing. A private market would develop, speculating on this upside, so the government could quickly unload—at a profit— the mortgages it had condemned and revised. By turning over the revised mortgages to private investors in this way, the government could manage the program with a modest investment of start up funds—far less than the amounts needed to buy all distressed mortgages outright (at inflated prices) and hold them for the long run.

Congress could pass such a law because the Constitution allows government to take private property (the mortgages and loans) for any public purpose with “just compensation.” Surely saving neighborhoods from destruction and the economy from collapse are public purposes.

Maybe some—maybe many—mortgage holders would consider the “prudent value” price “just compensation” and be content. Those that didn’t would have the same option that owners whose land is condemned for schools or roads now have: they could take the government to court, challenge the prices paid for their mortgages, and claim any additional amounts they could prove necessary to provide “just compensation.”

The same rule would hold for homeowners who didn’t like the revised terms, i.e., the retroactive down payment and appreciation-sharing on sale of the home. Homeowners who wanted better terms could also sue for “just compensation” for their confiscated financial interests. Likely far fewer of them than lenders would take this option. Most would likely accept the revisions as the price of staying in their homes for sustainable payments.

This plan would meet all three tests. It would immediately establish a price for each distressed mortgage, based only on the homeowner’s income. Since the revised payments would be sustainable, the revised loan would have value again, independent of the collateral’s uncertain value. The plan would act quickly, as it would require no bankruptcy or other legal proceedings. Lawsuits would come later; they would succeed only to the extent that interested parties could prove deprivation of “just compensation.” A single Supreme Court decision holding the price and revised terms “just” (or explaining how they could be made “just”) would forestall further litigation. And this plan would need no more than “seed capital” to start the acquisition process. Government could recycle that seed capital many times by selling successive groups of acquired and revised mortgages to the private market that would arise.

In addition to meeting the three tests for a good solution, this solution would have two other advantages. First, by putting a floor under mortgage pricing (the “prudent price” the government paid) and allowing an upside from that floor (the retroactive down payment and appreciation-sharing on sale), it would create a private market in revised mortgages. Second, it would be fairer and simpler for homeowners facing foreclosure, most of whom are financially and legally unsophisticated.

Homeowners would have the opportunity to challenge the revisions of their mortgages as depriving them of “just compensation.” So, too, would the lenders or present holders of the mortgages be able to challenge the acquisition price. But in practice the latter would most likely take that option, relieving the hapless homeowners of the burden of filing for and maintaining bankruptcy proceedings.

Thus the predators, not the prey, would have to deal with courts and lawyers, while simple administrative procedures could keep people in their homes and create a private market in revised distressed mortgages. Similar procedures might even put people back in their homes (if still vacant, and if the former owners still have income) after foreclosure and eviction, thereby helping to restore distressed neighborhoods.

Conclusion

There is a real and workable solution to the mortgage-housing part of our financial crisis. It is not John McCain’s solution. His would explode the national debt and create fiscal paralysis by requiring the government to buy and hold mortgages for the long term at inflated prices. Nor is it Barack Obama’s current solution, which would require millions of homeowners to file for bankruptcy and overload our bankruptcy courts.

A better solution is having the government condemn and acquire mortgages at a reasonable, prudent price and revise their terms, forcing mortgage holders to sue for more just compensation if they don’t like the price, or homeowners to sue if they don’t like the revised terms. This solution would clear the assets logjam quickly, with lower and more sustainable cost to the government. It would also put the burden of dealing with courts and lawyers on those who most deserve it: the folks who created this mess.

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2 Comments:

  • At Tue Oct 28, 02:26:00 AM EDT, Blogger proca said…

    Hello
    I would like to know why so many people default on their mortgages. If you stop paying and you borrowed 150.000, the bank sells your house for 100.000 USD now, and takes you to court for the rest of the money, right? This is how it is in Romania. Sorry if my question is foolish.
    Thank you

     
  • At Wed Oct 29, 10:43:00 AM EDT, Blogger jay said…

    Your question is not foolish, but I’ve already answered it at length in another post.

    So many people are defaulting on their loans because unscrupulous and unregulated mortgage lenders (not banks) sold them mortgages with interest rates—and therefore monthly payments—that stepped up substantially after two years or so. No one worried about these terms because everyone thought home values would continue increasing forever, so a homeowner having difficulty paying could simply sell the house at a profit.

    Whether a mortgage lender can take you to court for the difference between the loan amount and the home value (called a “deficiency”) depends on the U.S. state where the home is located. If the state has “anti-deficiency” legislation, the lender must be satisfied with whatever it can get by selling the home in foreclosure. If the state has no such legislation, then the homeowner remains liable for the deficiency. So the answer varies from state to state inside the U.S.

    All this is a good object lesson for other nations. A nation that devotes its best minds to “innovative” financial instruments like predatory mortgages and mortgage-backed securities is a nation in decline.

    Maybe now that that financial house of cards has collapsed, we Americans will return to innovating where it matters: in science and engineering. Maybe then we can begin to solve our energy crisis.

    Jay

     

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