Monday, March 2, 2009

I can understand the political appeal of mortgage relief, but from a strictly economic standpoint it does not seem a good idea.

From the Becker-Posner blog:

The President's Plan for Mortgage Relief--Posner

The President on February 18 announced a $75 billion plan with the following elements:

1. Refinance. The government will allow Fannie Mae and Freddie Mac--the large, now governmentally controlled buyers and underwriters of residential mortgages--to refinance mortgages when the unpaid balance of a mortgage is between 80 and 105 percent of the market value of the house.

2. Modification. The government will create financial incentives for lenders to modify subprime mortgages so that monthly payments are no more than 31 percent of the borrower's income.

3. Liquidation of mortgage-backed securities. The Treasury Department and the Federal Reserve will buy mortgage-backed securities from Fannie and Freddie; the cash received by Fannie and Freddie for these securities will give the companies more cash to buy mortgages.

4. Cram down in bankruptcy. The Administration will push for a change in bankruptcy law to allow bankruptcy judges to "cram down" mortgages on primary residences to the mortgage's market value. The unpaid balance of the mortgage above the cram-down level would be an unsecured debt of the borrower, which he would pay to the extent able to do so, and probably therefore in a considerably reduced amount, in installments.

I deal first with the specifics, and then offer some more general points.

1. The concern underlying point 1 (Refinance) is that homeowners who owe more on their mortgage than their house is worth may abandon the house, as one would, if one could, any other net liability. As a practical matter, the mortgagee will rarely be able to collect the difference between what is owed and what the house will fetch at a foreclosure sale. But there are costs of abandoning a house--in particular, one has to find another place to live--and if the homeowner thinks the market value of his house will rise and exceed the unpaid balance of the mortgage in the not too distant future he may well decide to stay and pay.

2. Subprime mortgages are at great risk of default when housing prices fall; often the mortgage was viable from the borrower's standpoint only if housing prices kept rising, as in the case of a 100-percent (no down payment) mortgage, where without a rise in the value of the house the mortgagor will have no equity in it. Reducing monthly payments will enable some of these mortgagors to keep their home.

3. There are at present virtually no private purchasers of mortgage-backed securities. These are frozen assets. If the government buys them from Fannie Mae and Freddie Mac, Fannie and Freddie will have more cash with which to buy mortgages and by doing so inject cash into the housing market.

4. Cram down of secured loans in bankruptcy is common; the exclusion from cram down of mortgages on primary residences is anomalous (cram down of a second residence is permissible). Allowing cram down of mortgages on primary residences would reduce the monthly payments of homeowners who declare what is called Chapter 13 bankruptcy, the counterpart for individuals of corporate reorganization. In Chapter 13 bankruptcy the debtor cannot just walk away from his debts, but must agree to pay some fraction of them on the installment plan for several years.

The four measures, taken as a whole, are likely to be administratively complicated, costly, and slow, and so have very limited effect in arresting (let alone reversing) the decline of housing prices by reducing the glut of houses for sale as a result of widespread foreclosures. Number 4 fails on both grounds; bankruptcy is a complicated proceeding and having to declare bankruptcy, especially under Chapter 13, which does not wipe out all one's debts, will be an unattractive option for even mortgagors otherwise inclined to abandon their house. Number 3 involves the vexing problem of valuing mortgage-backed securities in order to decide what to pay for them. Numbers 1 and 2 are administratively very complex because they involve (as does 4 for that matter) separate negotiations or proceedings for each mortgage.

Although $75 billion is a large amount of money, total residential-mortgage debt in the United States is in the neighborhood of $10 trillion, and some 10 percent of the total number of mortgages appear to be in default or in jeopardy of default even if the economic picture does not darken further. An injection of $75 billion would have some effect in reducing the amount of housing indebtedness, and in turn overall indebtedness, and indebtedness is an obstacle to economic recovery. But given the administrative complexities, it will probably take a long time for a significant fraction of the allocated amount actually to be spent. Moreover, it is only after the mortgagor receives financial relief that he can begin to increase his personal consumption expenditures, and until that happens the increase in output and employment will be slight.

The announcement of the program has engendered some anger among people not eligible for relief; they will be paying in taxes or other ways for a large share the $75 billion. Still, they will derive benefits if the program causes the depression to end sooner (which may indeed lighten the tax burden), or if they find themselves unable to make their own mortgage payments, even if they are able to do so now. I do not think concern with moral hazard is a serious objection to the program. It is hard to imagine people buying houses with subprime mortgages (even if anyone is willing to offer such a mortgage) in the thought that if they can't make the payments the government will bail them out; for I assume the program will not extend to people who take out subprime mortgages after the program was announced. But if Chapter 13 is altered to permit cram down of mortgages on primary residences, the alteration will presumably be applicable to future as well as current mortgages, and this means, as the real estate lobbyists point out, that mortgage rates will rise to compensate lenders for an increased risk of not being able to enforce their full security interest. But of course higher mortgage interest rates will reduce the probability of another housing bubble, and so may be a good thing.

One of the missing links in the program is the sensible proposal by an interdisciplinary group at Columbia University to pass a law that would permit companies servicing mortgages pooled in mortgage-backed securities to modify mortgages in the pool without requiring the consent of all the investors in the pool, even if the security agreement requires unanimous consent by them. That would reduce the transaction costs of modification and by increasing the number of mortgage modifications would reduce the number of foreclosures.

I can understand the political appeal of mortgage relief, but from a strictly economic standpoint it does not seem a good idea. The administrative complexity bothers me a lot. The federal government is taking on so many burdens these days that its ability to deal effectively with millions of mortgagees (the goal of the program, though unlikely to be attained, is to provide mortgage relief to nine million homeowners) is probably very limited. What is true is that the avalanche of foreclosures may be depressing the price of housing below its long-run equilibrium, but if so a simpler approach would be a six-month moratorium on foreclosures, based on a hope that by then the economic situation will have improved to the point where modification and refinancing of mortgages can reduce the foreclosure rate to a normal level. Yet even such a measure would be undesirable because any measure that injects uncertainty into the already uncertain economic environment of the banking industry is bound to delay the recovery of that industry, and the longer that recovery is delayed, the longer and deeper the depression will be.

Posted by Richard Posner at 7:02 PM"


On the Obama Mortgage Plan-Becker

The housing market is in shambles as home prices continue to fall-so far the average house has fallen over 25 percent in value from its peak. New home construction has virtually stopped. Two causes of the bubble in both housing prices and construction are low interest rates that made durable goods like housing more attractive, and unjustified optimism on the part of both lenders and borrowers that housing prices would continue to rise at a rapid pace. Also of possible importance was the inducements provided banks and other lenders by the Community Reinvestment Act and the 1992 Housing Bill to increase loans to subprime buyers. In 1994 subprime mortgages were under 5 per cent of all mortgages, but by 2006 they were about one-fifth of all mortgages, although the precise roles of this legislation and general optimism about the housing market in the increasing share of subprime mortgages has not been established.

In normal economic times, the housing market would be allowed to continue to work off its excess capital stock through still lower housing prices that increased demand for housing, and minimal levels of new housing construction that reduce the supply of housing. In addition, the government might have retreated from encouraging mortgages to persons with poor credit histories and low earnings. The President's plan is to encourage new housing construction partly by seeking to keep mortgage interest rates low for middle class families taking out new mortgages. To achieve this goal, both the Treasury Department and the Fed will continue to buy mortgage-backed securities from Freddie Mac and Fannie Mae, and Treasury will provide up to $200 billion in capital for this purpose. Likewise, instead of reducing subprime mortgages, the President's plan would stabilize and even increase them by giving lenders financial incentives to reduce interest rates to subprime borrowers, and also by cutting mortgage payments on these loans to no more than 31 percent of borrowers' incomes.

Of course, these are not normal times since we are in the midst of a serious recession that will get worse before it gets better. Does the recession, and the high foreclosure rates on homes, justify these unusual steps that will retard rather than hasten downsizing of the housing market? I do not believe so. Posner shows that the plan has many unattractive features, including that it would be a bureaucratic and administrative nightmare. In addition, it will almost surely cost far more than the $75 billion price tag that the administration attaches to the plan. This magnitude of spending on a complicated housing program seems like a bad idea when so much money is being committed toward other programs to help the economy: about $800 billion in a fiscal stimulus package, and probably much more than that in the Treasury's and the Fed's efforts to help banks become solvent and active in the lending market. I am also worried about increasing Fannie and Freddie's stake in the housing market when their policies have contributed significantly to the excessive sub prime mortgage lending.

In a prior post (see my "On the Obama Stimulus Plan", Jan. 11th, 2008) I expressed my skepticism about how much short term effect on the economy will be produced by the fiscal stimulus package since it mixes long term changes in the economy that will have negligible short term stimulus effects-such as support for alternative energy sources- with helping the economy get out of the recession during the next couple of years. I am more confident that the Fed's policy of lowering interest rates and creating bank reserves through open market operations will succeed in stimulating banks to further increase their lending. I also believe it is necessary to increase the liquidity and capital of some banks, and to close other banks that are no longer viable, although so far the policies to do this advanced by the previous and current Secretaries of Treasury do not seem well thought through.

To return to the housing market, during previous housing busts, banks that were heavily involved in the mortgage market would try to avoid foreclosing on properties during bad times since it was costly for them to take possession of large numbers of houses. They would stretch out mortgage repayments, and even cut the amounts owed in order to help borrowers get through difficult times. That did not prevent sizable increases in foreclosures during highly depressed housing markets, but it did keep the number of foreclosures well below the number of borrowers who experienced difficulty in meeting their payments.

It appears that that the relatively simple decision of lenders to avoid foreclosures is much more difficult when banks and other lenders have sold off the mortgages they originated into mortgage-backed securities that pool mortgages originated by many different lenders. For it is not easy to restructure only the fraction of the mortgages that need restructuring in securities that pool a large number of mortgages. I believe there is a case for making it much easier to restructure mortgages in such securities; indeed, to make this more comparable to the ability to restructure mortgages under the old system when banks held on to the mortgages that they originated.

Posted by Gary Becker at 5:37 PM "


If we were fairly sure that housing prices were near a bottom, a subsidy and some aid in unwinding some mortgage problems through government intervention might make sense. My problem is that I don't believe that anybody really knows where the bottom is. If we stabilize the price at too high a level, then we will either have to continue the subsidies indefinitely or allow another annoying correction, which could reverse a recovery going forward.

There is a plausible political rationale for this intervention, which is that it will not look good if the only people that get bailed out are in the financial sector.

Posted by Don the libertarian Democrat at March 2, 2009 2:41 PM

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