There is, Perhaps, a Grimmer Truth
posted by Nate Oman
Lawrence rightly notes that the first round of oversight reporting to Congress on the bailout makes for grim reading. Unfortunately, I suspect that some problems are grimmer than even Elizabeth Warren and her associates make out. The TARP Oversight Report is quite insistant on the need for the Treasury to take action to decrease home foreclosures. It points out, quite rightly, that foreclosures tend to reduce the value of abutting property, further fueling the drop in home prices. The report says:
Federal Reserve Board Chairman Bernanke recently reported that foreclosures in 2008 will number approximately 2.25 million. Neighbors see their home prices decline from blighted nearby properties, and foreclosure sales saturate the real estate market with lowpriced inventory, further pushing down home prices. Foreclosures also place a double burden on local governments, as they impose direct costs from crime and fires while eroding the local tax base. Global asset write downs and credit losses relating to home mortgages currently exceed $590 billion and may eventually rise to $1.4 trillion by some estimates. Moreover, foreclosure rates have continued to increase in recent months, and one in ten American mortgage holders are now in default or foreclosure. Rapidly rising unemployment is likely to increase mortgage defaults and drive foreclosure rates even higher. Several economists have identified the unresolved foreclosure crisis as a key causal factor in financial instability and economic decline.
There are basically three different approaches on the table for dealing with the problem. First, the Treasury department can work to make more credit available for home financers. Second, the government can encourage institutions to voluntarily renegotiate loans, perhaps by putting some of the government’s own credit behind the renegotiated loans through some sort of guarantee. Third, we could amend the bankruptcy code to allow the loans to be trasformed in bankruptcy from subprime monsters into more managable beasts like 30-year-fixed rate obligations.
It seems very unlikely to me that any effort to rengotiate mortgages voluntarily will succeed. The problem is that the ultimate lenders are hopelessly fragmented holders of MBSs with whom one cannot practically negotiate. The servicers, with whom one can negotiate, have little incentive to do so and face potentially huge liability if they do. Refinancing is a better option, in that the negotiating problem is much simpler. A home owner only has to negotiate with a single new lender to obtain funding, rather than with hundreds and perhaps thousands of untraceable holders of MBSs. The problem here is economic. Who wants to refinance a home loan that is already underwater?
This leads us to modification in bankrtupcy, which of these approaches strikes me as the most promising. On the other hand, I am not sure how promising it actually is. The question is how many of these loans would actually end up performing were they coverted into, say 30 year fix rate mortgages? There was a reason that these borrowers could not actually obtain 30 year fixed rate mortgages to begin with: lenders didn’t think that they would pay them off. Notice, these were the same lenders who were so wildly optimistic about rises in future asset prices that they were making no-doc, no-equity loans. If a wildly optimistic market before the bursting wasn’t willing to make 30-year-fixed loans to these borrowers, it seems rather unlikely to me that — facing a nasty recession — these borrowers have suddenly become a good bet on those terms. If they aren’t a good bet, then we haven’t actually halted foreclosure. We’ve simply delayed and prolonged it. Of course, if you believe that lots of these folks were denied 30-year-fixed deals on the front end because of abusive lending practices, then maybe we would be right to think that the market improperly assessed their risk back then. I’ve no doubt that this is true for a large number of borrowers. On the other hand, I would be surprised if the number of good-risk borrowers shunted into subprime mortgages by over-reaching brokers is large enough that we can seriously stem the flood of foreclsures by giving them in bankruptcy what was denied them ex ante by the market.
Unfortunately, I suspect that there is a grimmer story to be told here than hard-working middle-class families caught up in the abusive greed of over-reaching home lenders. If that was the problem, there would be a relatively easy and reduced pain (if not painless) solution. The grimmer story is that we have a huge over-supply of housing in this country. Certainly, the unoccupied housing rates are at historic highs. If this is true, then we have a classic problem of supply and demand. When supply is too high, the market will only clear if prices drop. Dropping prices, however, will fuel foreclosure and scare off lenders, who quite rightly will not be eager to write loans unless they believe home prices reflect a market clearing price. We can push government policy designed to keep prices up in order to make home-owners like me feel more secure in their single biggest asset. We can try to maintain home prices in order to reduce the incentive for lenders to foreclose and for borrowers on a non-recourse basis to walk away. On the other hand, so long as we have an over supply, prices must come down, and until they do both lenders and buyers will want to sit on the sidelines. From my house I can see three homes that have been on the market since late summer. They will not sell unless their prices come down.
Unfortunately, we know what an economy looks like when government takes aggressive action to cushion the blow of a bursting asset bubble by working to prop up asset prices. It’s called Japan in the 1990s.
December 12, 2008 at 1:14 pm
Posted in: Bankruptcy
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Responses (4)
Mark Edwards - December 13, 2008 at 12:37 pm
“Who wants to refinance a home loan that is already underwater?”
One problem with living in a country that continually re-invents itself is that we sometimes forget even our recent history. We’ve answered this very question in the not-too-distant past. As I recently wrote about here, the Roosevelt Administration created the public/private hybrid Home Owners’ Loan Corporation (financed partly publicly, and partly through tax-favored private investment).
“This institution had a simple but crucial mission: buy delinquent mortgages from home lending institutions, then work with home owners to refinance them on less risky and more responsible terms. As a result, banks were able to sell mortgages they most wanted to be rid of, reducing their bad debt and increasing their liquidity. For homeowners, short-term, adjustable rate, and balloon mortgages were converted to long-term, fixed rate mortgages.”
http://www.concurringopinions.com/archives/2008/11/henry_paulsen_a_1.html
If it worked before — and it did — then why not now? Opposition to the idea seems more ideological than logical.
Bob Major - December 13, 2008 at 12:49 pm
The key, perhaps not so inconsequential, differences between the collapse of the Japanese real estate bubble and our own are: 1) the greater relative reliance of our economy upon serial bubbles and debt-fueled consumption and 2) our relatively lower national savings rate (zero).
Nations are wealthy to the extent they produce things people want to buy: serial bubbles and debt-fueled consumption are not a functional equivalent.
Mark T - December 15, 2008 at 10:04 am
Both Mr Oman and Mr Edwards are correct yet in conflict. The conflict is over the objective. Is the objective to reduce foreclosures and keep people in homes – which keeps the number of homes for sale down and prices up, but leaves those overpriced assets in the economy to depreciate over time? Or is it to eliminate the overinvestment in housing, which is stimulated by a number of federal tax and “regulatory” policies, promptly? I tend to side with Mr Edwards because I think human society does not handle rapid change well and I fear for the country if we exceed the rate of change people can tolerate. But intellectually it is a close call. I think the burden on Mr Edwards’ camp is to articulate a long term path toward less investment in housing, e.g., by phasing in a minimum downpayment requirement and by phasing down the mortgage deduction.
The same might be said for our over investment in automobiles.
Mark T - December 15, 2008 at 10:04 am
Both Mr Oman and Mr Edwards are correct yet in conflict. The conflict is over the objective. Is the objective to reduce foreclosures and keep people in homes – which keeps the number of homes for sale down and prices up, but leaves those overpriced assets in the economy to depreciate over time? Or is it to eliminate the overinvestment in housing, which is stimulated by a number of federal tax and “regulatory” policies, promptly? I tend to side with Mr Edwards because I think human society does not handle rapid change well and I fear for the country if we exceed the rate of change people can tolerate. But intellectually it is a close call. I think the burden on Mr Edwards’ camp is to articulate a long term path toward less investment in housing, e.g., by phasing in a minimum downpayment requirement and by phasing down the mortgage deduction.
The same might be said for our over investment in automobiles.
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