Recourse, Of Course

Martin Feldstein has written another Wall Street Journal op-ed (here’s an NBER version) extending his idea for stabilizing home prices. Steven Levitt has written about Feldstein’s basic idea before. The basic idea is for the government to provide low-interest loans to mortgage holders in return for mortgage debt:

The federal government would offer any homeowner with a mortgage an opportunity to replace 20 percent of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2 percent.

The Feldstein proposal has a real advantage relative to Luigi Zingales‘s ingenious “Plan B.”

Zingales proposes that Congress pass a law to give a recontracting option to all homeowners living in a zip code where housing prices have dropped by more than 20 percent. If exercised, the Plan B option will write down the face value of the mortgage by the same percentage that the area housing price has dropped and, in return, the homeowner will give the mortgage holder 50 percent of any appreciation at time of sale. (Zingales points out that mortgage holders will do much better under this program than with foreclosures, where transaction costs eat up a hefty proportion of the market value.)

Feldstein, like Zingales, reduces the incentives for homeowners to default on their mortgages. But Feldstein avoids the sticky question of bank approval. Zingales’s plan tries to do this by legislative fiat. But a law that forces mortgage holders to accept a write-down of principle might violate the Constitution’s Takings Clause. Indeed, another parallel between 1932 and 2008 may be how the court responds to legislative innovation. (Here, Chief Justice Roberts plays the role of Charles Evans Hughes.)

But the Feldstein proposal has a couple of real disadvantages as well. Feldstein emphasizes that the government loan would be a “recourse” loan, giving the government the right to look to homeowners’ wages and other assets. Feldstein is critical of American exceptionalism with regard to making mortgages non-recourse:

The “no recourse” mortgage is virtually unique to the United States. That’s why falling house prices in Europe do not trigger defaults, since the creditors’ potential to go beyond the house to other assets or to a portion of payroll earnings is enough to deter defaults. Officials and investors in other countries are amazed to learn that U.S. mortgages are no recourse loans. It is indeed surprising that this rule in the U.S. applies to home mortgages but not to any other type of loan.

Feldstein’s proposal, however, goes beyond merely making the government loan “recourse.” Feldstein would not make the loan eligible for relief in bankruptcy.

To me, it’s an open question whether many homeowners would accept the bribe of a subsidized write-down in third-party mortgages in exchange for taking on a recourse, no-bankruptcy loan. In scary economic times, many homeowners might be reluctant to take the Feldstein option.

The big concern is that we still may be on the brink of an even larger foreclosure disaster — with wave upon wave of foreclosures feeding back to reduce housing prices, thereby inducing more homeowners to walk away from their mortgages.

To stabilize things, we need to solve what economists call a “participation constraint” problem. We need to either 1) meet homeowners’ participation constraint (offer them a deal that is worth taking), 2) meet mortgage holders’ participation constraint (hard to do because ownership is so fractionated), or 3) take on the hard question of cramming down a legislative solution that roughly makes the different participants better off.

(Hat tip: Roberta Romano)


science minded

what will that do? Make us more indebted! Why not start a mortgage company and re-organize the debt. to meet the reality- my house is worth less than I paid for it and possibly less than what I would get if I sold it after the debt was paid.. Unless I add a few rooms with the money I would be supposedly lent and then raise the value of my house, increase my taxes etc.,etc.But what a risk to take.

Seems like a devaluation process is in order. Frankly, the mortgage companies ought to incur the loss to me of the value of my house and refinance at the real value, with a 30 year mortgage. That would take the stress away from me.the owner, the mortgage company could incur the loss as a tax break. Part of the loan deal could be, payable by the fifth of the month (with a 75$-100 fee thereaftter) not the 16th- giving the mortgage company an extra 11 days to fool around with my money- Everyone would benefit. Do quote me on this- our government seems to need a bit of help in solving the mortgage problem. Here is one solution and my guess is, it is probably the fairest around to all concerned.

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thomas

It is a collateralized loan, why does there need to be recourse. If you default, then the bank gets the house and your credit score is ruined.

Gary

I'm not sure this would address the true problem, which is that median home prices are not in line with median incomes across the country based on historical data. Until home prices get reasonably in line, home prices will decline in value. Lowering the interest rate on a portion of the loan would certainly lower the payment, but I'm not so sure it'd lower it enough to bring the market back to equilibrium.

While a low interest recourse loan would decrease the cost (in dollars) of purchasing a home, there is a cost implied in moving fron a non-recourse loan to a recourse loan... especially when the lender has the power of the federal government. Ask those that defaulted on federally subsidized student loans how this has worked out for them. Now, in my opinion, the student loan defaulters are a bunch of whiners who should have paid their taxpayer backed debts, but its not as if the lower interest rate was a free lunch. Those that defaulted significantly impacted their lives by doing so, ruined credit (which can close some doors for employment), never get a tax refund, garnished wages... Their situation would be far less dire if they defaulted on a higher interest private loan.

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sara

@1...why in the world should the mortgage company be responsible for YOUR bad choices in purchasing a house you couldn't afford that dropped in value? If you had made wise borrowing choices in the first place, it wouldn't matter that house prices had dropped...you'd be able to pay it off now as you were able to when you took out the loan. it amazes me how entitled people feel for private companies to incur losses because they CHOSE to make a bad deal!

Ben D

I prefer the Zingales plan, but both are preferable to most ideas that have been proposed by our "leaders" in Washington. What is the chance that one of these tough-but-fair type plans actually gets adopted?

MikeM

You know what, as a renter who has been waiting the housing market, I'm getting more and more indignant by the day. I'm sorry to you people whose houses are worth less than you payed for them, but that's what happens to things we buy. My car is worth a lot less than when I bought it new, but I've derived a lot of utility from it in the mean time. Yes, a house is an investment, but it's also a purchase. Please don't forget that.

If you live in a nice home, can meet your mortgage payments, and then walk away because you don't like the value of your home anymore, you should be ashamed of yourself. How about sucking it up, and continuing to enjoy the nice home you have.

PaulK

@thomas, the point is that the Government would not get a piece of the house if you default, so they go after your other assets now and into the future (wage garnishment for example).
@science minded, just writing off some chunk of the mortgage would be a big gift to you and would likely expose the mortgage holders to more grief than now (since not everyone underwater will default, for obvious reasons). The Zingales solution was to forgive your excess over FMV, but only if you agree to share any proceeds when you do sell - that is, it recognizes that once prices stabilize, your house will in fact be worth more than the mortgage again. So, it is only a gift to you if the FMV never gets above the mortgage. That makes it like a short sale (where the mortgage holder takes whatever you get and eats the loss), but only if there is no gain in the future.

Cliff

I don't understand how so many people talk as if all U.S. mortgage loans are non-recourse. Aren't most U.S. mortgage loans recourse? I think only in California are they mostly non-recourse.

Nevertheless, as a practical matter banks rarely go after the shortfall. What would happen if the government was the lender and defaults were commonplace? Millions of civil suits brought by the government against the ex-homeowners?

Sam

I wrote to my Senator, Chris Dodd. Asked him to get to work on legislation that would allow me as a homeowner to put aside a protion of my pre-tax income (see 401k) to pay down my mortgage principal.

Have not through through all the details of how it would work, or the reasons it is a good idea, or a bad idea... Just that it might be better than loosing over 40% indexing the S&P 500.

He hasn't gotten back to me yet.

The next move is to reach out to Howard Pitkin, Connecticut's Banking Commissioner. Dodd, I think, respects him.

DavidG

Having both the ability to repossess your house _and_ to make a claim against future income or other assets creates a conflict of interest for mortgage lenders. When a house is repossessed, the lender has a duty to get the highest possible price for it. If they know they can go after other assets or income, that incentive is lessened.

I agree with Thomas above -- if the bank takes collateral (i.e. a lien against your house) -- then that's their protection. It's true that a lot of borrowers made stupid choices, but so did banks. Before the latest bubble lenders used to insist that borrowers finance no more than 80% of the purchase price. That gave them pretty good coverage in the event of a default.

Banks really hung themselves. Nobody forced them to write stupid loans.

Smitty

Does anyone see this the way I do? That this was the swindle of all swindles? Let's take a bird's eye view of this, as if we are aliens studying this from afar:

If I can convince a group of people that the 'widget' I'm selling is worth 5 times its actual value, so much the better, right? I make money, everyone is happy, because they paid a price they considered fair.

Houses were sold the same way, as 'widgets'. People bought the homes at prices way above the historical median, drawn in by the hysteria of the moment, and being told that "prices are only going up".

All of this would have been fine if not for mortgages: a promise made by the holder to pay over 30 years (30 years!!) each month, with the punishment of losing a down-payment and a home if the payments could not be made. Folks have to pay this loan for their entire working ife, and in exchange they can own property when I retire, and pass this to their children when they die. The strength of this promise (read: contract) is based on the buyer's integrity, and perceived ability to pay.

Now, when this idea was conceived, this seemed like a pretty good bargain for both sides: the mortgage holder was able to "own" property, thus being in greater control of their lives, and the mortgage company was guarenteed of a steady return on the loan for many years.

But look at how things have changed: is this now a fair deal, or a devil's bargain? Is it any wonder folks want to walk away from something now perceived as a raw deal? By loosening the restrictions on mortgages, and allowing more folks to have one, all we have done is increased demand for this item and started a bidding war for homes. Do we then try to artificially prop up the market at unsustainable prices? With taxpayer money???

Unfortunately, there is no "fix" for this problem aside from lettting the folks who were swindled either decide to make good on their promises or leaving the deal behind, and suffering the consequences. We should not protect the "swindled" or the "swindlers" from the consequences of their actions. We do, however, have to make sure it does not happen again, and to protect the innocent.

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Bill Brown

@DavidG, actually, I think the banks were required to make loans they wouldn't otherwise have made by the Community Reinvestment Act of 1977. At least, if they wanted to receive FDIC insurance, they were.

thomas

The Community Reinvestment Act applies to depository banks. But many of the institutions that spurred the massive growth of the subprime market weren't regulated banks. They were outfits such as Argent and American Home Mortgage, which were generally not regulated by the Federal Reserve or other entities that monitored compliance with CRA. These institutions worked hand in glove with Bear Stearns and Lehman Brothers, entities to which the CRA likewise didn't apply. There's much more. As Barry Ritholtz notes in this fine rant, the CRA didn't force mortgage companies to offer loans for no money down, or to throw underwriting standards out the window, or to encourage mortgage brokers to aggressively seek out new markets. Nor did the CRA force the credit-rating agencies to slap high-grade ratings on packages of subprime debt.

- from Slate columnist Daniel Gross

Kimota94

As someone who worked in a bank for a decade and a half (in the technology department, but still), I always thought there were good reasons why there were limitations on who the bank would give a mortgage to. Those criteria were based on income, current debt, and credit history. And the banks also determined what they considered to be a "safe" (i.e. likely to be repaid) amount to authorize you for, rather than letting you walk in and demand a $500,000 mortgage on your $80,000/yr income. Certainly that meant that some people who desperately WANTED to own a house couldn't, but I don't think it ever stopped anyone who COULD AFFORD to own a house from getting it.

It's really too bad that that all changed in recent years. I know everyone may feel like they're entitled to home-ownership, but the reality is that you really have to be able to afford it, first.

As for the person (# 1, above) who feels that someone else should be held accountable for the fact that his house is currently worth less than he paid for it, would he also have been eager to give away the profit if instead the house's value had gone up by 50%? If not, then he really needs to re-think his position. I sold my first house for a 30% loss (the market changed for the worse in the 8 yrs between when I bought and when I sold) but understood that that was simply how things can go. My current house is valued at 50% more than what we paid for it 10 yrs ago, but since we're not planning to move anytime soon, it's not really all that relevant.

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Walter G

@ you know who you are:

Why do we as tax-payers have to be responsible for the bad choices that mortgage companies made to loan to subprime borrowers? It amazes me how entitled mortgage companies feel that the public sector should incur losses because they made bad choices to lend to people they knew would default.

-your friendly neighborhood Antithetical

Sandy

In America, mortgages are non-recourse loans for two reasons. First, our legal system (with the exception of Louisiana, which derives its laws from France's Code Napoléon) is derived from the English system; a hallmark of English, and thus American real property law is the difference between "in personam" and "in rem" jurisdiction. "In personam" refers to laws and causes of action against individual persons--be it criminal, contractual, tort-based, etc. "In rem" refers to laws and causes of actions derived against things or objects, chief among these objects being buildings and land, as well as the collateral for "purchase money" loans (e.g., home mortgages and cars) and secured secondary loans on real property (i.e., refinancing of mortgages). When someone incurs mortgage debt, the debt in legal reality is that of the object being financed, i.e., the home. (This is so even when a person signs for or assumes a mortgage). The evidence of the secured loan is the promissory note--which states that the recourse for failure to meet the obligation is repossession of the object securing it, according to a lien created by a separate instrument: the mortgage. A lien, since it attaches to an object, is by its very nature in rem and limited to the object, not the debtor.

In normal times (most of modern history until now), a mortgage was a relatively low-risk loan. People defaulted on mortgages because they were unable to meet the payments, regardless of the property's underlying fair market value; because of their financial track record and deficient assets they could not meet requirements lenders imposed for refinancing on easier-to-comply terms. When a home was repossessed by foreclosure, the lender always came out at least even--it could sell at a foreclosure sale for the amount still owed, or decide to sell it for fair market value and take a profit since most real property appreciates over time. The debtor homeowners, if they were lucky and their state law permitted, were able to recoup the equity they had at the time of purchase--the down payment they made. As to car loans, recourse is usually limited to repossession (though more and more new-car loans provide for additional recourse despite being secured by the vehicle; the debtor's equity diminishes and usually disappears because nearly all personal property--except for rare collectibles and precious substances--depreciates).

That being said, it is an exaggeration to say that people who can afford their mortgages are "walking away" in a snit over declining equity. The vast majority of foreclosures today occur on properties for which the homeowners cannot afford to meet their payments and cannot qualify to refinance to an affordable interest rate and monthly payment. It is a very recent nationwide phenomenon for lenders to be stuck with properties that are "underwater," i.e., worth less than the mortgage balance. Until the past year or two, this was such a rare occurrence that it never occurred to lenders to seek an additional loan (with recourse) over and above the one secured by their lien (the mortgage) on the property itself. We may well start to see a break from the English legal tradition in the U.S. and see home sales involving personal-recourse loans in addition to mortgages.

In that case, today's foreclosure tragedy will be dwarfed by the widespread poverty, despair and chaos that is sure to come and which will make 2008 referred to as "the good old days." Be careful what you wish for!

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aaron

Part of the problem is that when default risk went up, buying slowed and so values on homes went down. This means that for many people, if they sell they are still stuck with a sizeable debt and no asset to lose if they default on it. And banks end up with an oversupply of properties it can only sell at firesale prices, which push home prices down further.

Here's a way to mitigate some of the problem.

Upon sale or foreclosure, the bank gives the borrower difficult to sell foreclosed properties on its books for the value, or partial-value, of the remaining debt.

PaulK

The point of collateralized loans has always been that the main recourse is the collateral itself. As has been noted above, this has traditionally worked well since the issuer of the loan only lends up to a percentage of the FMV and factors in future value in that decision (so cars are assumed to lose a lot of value, homes in some areas go up and in some stay about the same). The current problem has nothing to do with CRA, so stop that (right wind talk radio) canard.
The current problem is simply that loan-to-value was set at near or over 100% for too many people with reduced chance of being able to pay the mortgage past the 6 month packaging period. Part of the argument was that the home value would go up fast enough that the borrower could sell or refinance in the future. The brokers and front-end lenders were doing this because they could package these together and hide the details (and pick up points on the initiation of the loan). Those buying a portion of the package (securities) were assured of their safety through rating of the bonds and/or CDS (insurance against default); those ratings (or CDS price) were based on historical default rates. Each piece introduced risk somewhere, but it was still an OK model during the bubble (since homes did in fact go up in value, the borrowers could sell out of the house or refinance, the packages had few defaults, the CDSes were rarely called, the borrowing against the assets of the securities and CDSes were rolled over, etc).
Like any system built on non-redundant safety, cracks formed at a few places and the whole system collapsed on itself. Once defaults started to rise, mark-to-market rules required downgrading the asset (and so the margin loans were called or roll-overs held), CDSes started getting called in higher numbers than predicted, etc. Each component had a failure acceleration factor built in (not intentionally of course, the model was based on slow changes and historical averages).
The problem for homeowners is that we are blaming many who did nothing wrong. They bought homes using reasonable mortgages (20/80 or 15/85) using the current value of the home (of course). But, once defaults started going up, then lending started shutting down and the value of homes dropped (no one could buy houses at the offering price since no loan, and foreclosures depress value due to below market sales (dumped by the bank)) and so they suddenly were underwater. Saying that most people should have known is absurd. A few areas were unrealistic (Las Vegas comes to mind, but other sub-prime specials). The point is that some borrowers should never have taken the loan, but many followed all the rules properly and still got caught by the burst bubble.

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California Realtor

Zingales' plan has 2 big weaknesses.

1. In California, most loans ARE recourse loans. Only original purchase money loans are non-recourse. If you ever refinanced, you have a recourse loan. Most of the financial distress sales that I'm seeing are on refinanced loans. These people are in for a rude shock 3 years down the road when the bank comes after them for the remainder of the money.

2. From a financial point of view, it's a raw deal for the homeowner. On the upside, if there is ever a recovery, the homeowner misses out on 1/2 of it. On the downside, that homeowner has given up any hope of financially recovering from his mistake (or fraud). Most people aren't desperate enough to stay in their homes to see any appeal to this.

Finally, let me say a word to everyone here who is indulging in a bit of schadenfreude at the expense of people who can't pay their mortgages. Don't worry - They are going to suffer plenty no matter what the government does. Last month, I showed one of these foreclosed homes to a buyer of mine. We found the artwork of the former owner's children in one of the closets. It was heartbreaking

The only way our economy is going to recover from this is for your tax money to go to someone who don't deserve it. Whether that person is a bank president, a wall street trader, or a homeowner is a question for the next administration to decide. However, you can be sure that fairness will not be a factor. If you try to design a bailout based on fairness or worthiness of the beneficiary, it will fail.

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Chee Heong, Quah

Totally disagree with Martin Feldstein's call to dismantle EMU.

If EMU were to be dismantled, then perhaps California the state where the housing bubble started or originated also needs to be independent from the United States!

Since unemployment rates in all the 50 states in US are different, each state should best have its own monetary policy and currency. And if that's not enough, every single unemployment pocket in the economy should have a separate currency and hence we shall regress to the barter system.

Flexible rates just don't solve the situation but could even make matters worse if the economies of France and others are to remain open in trade and capital movements.

First, the problems are just not the exchange rates but the real fundamentals of the economy that are rebalancing and readjusting after the housing boom. The factors of production are reshuffling.

And even if the French nominal exchange rate is lower, would the real exchange rate will also be lower? Even if that's true, the world now is in recession, so are you asking France to export to the Mars? Come on, this is no time to ask for beggar-thy-neighbor policies.

In fact, euro has brought stability and integration to the area which has made euro the second most preferred reserve currency.

Countries which underperform vis-a-vis Germany might most likely suffer not only the existing problems but also a currency crisis if the exchange rates were to be flexible and the capital account were to remain open.

As long as the ECB is not inflationary and factors of production are mobile and flexible across EU, this is the optimal arrangement you can get. Crises strike regardless.

And remember the gold standard worked well until WW2 so unless a catastrophe as dreadful as WW, fixed exchange rates are the best solution.

Don't move from bad to worse!

Please read Robert Mundell and Ronald McKinnon.

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