Bankruptcy

The Role of Recourse in Foreclosures

By Adam Levitin

Martin Feldstein has been pushing a mortgage bailout proposal that has been getting some undeserved attention (see here and here, e.g.).  Feldstein gets  (here, and here) how central negative equity is to the economic crisis.  Homeowners with negative equity have a reduced incentive to stay in their home if the mortgage is burdensome.  Negative equity fuels foreclosures, which in turn force down housing prices, setting off a downward spiral. Feldstein is right to focus on negative equity as a key issue for housing market stabilization. The problem is in his solution--it is based on a few erroneous factual premises, all of which could have been discovered with very limited Google searches. 

Feldstein argues for the government to partially refinance mortgages with low-interest loans.  That?s not a unique idea, and the problems involved with having the government assume private mortgage debt (e.g., bail out lenders and socialize losses) are well-known. 

Feldstein adds a twist, though.  He recognizes the problem with socialized losses and tries to guard against that by insisting that the government refinanced part of the mortgage be ?recourse??that is the government could look not just to the house for satisfaction of its debts, but also to the homeowner?s other assets.  (Feldstein would also make this debt non-dischargeable in bankruptcy, something which rightly gives Ian Ayres pause.)   

Feldstein believes that having ?non-recourse? mortgages is a major factor encouraging homeowners to walk away from underwater properties.  He writes:

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 is astoundingly uninformed.  Even the most cursory glimpse at the European mortgage market shows that Feldstein has not done the type of research necessary to make an intelligent international comparison, much less reach his specific conclusions.  (Just to talk about a ?European? mortgage market is problematic?real property law remains intensely local.) 

What scares me is that this proposal has gotten a fair amount of attention (and not just from other economists, but from policymakers too, although there are no weblinks I can post) simply because Feldstein?s name is attached to it.   When celebrity economists jump into policy debates without having done their homework it gunks up the policy discussion and distracts policymakers from the well-informed and thoughtful proposals (of which there are several around).

So what specific errors have me so hot under the collar about Feldstein?s proposal?

First, Feldstein doesn?t know from Adam whether US mortgage lending is recourse or not.  It is very hard to generalize about US foreclosure law.  It varies state by state has often Byzantine complexities.  (Why we do not have uniform property law in an age of national lending is an interesting question.)  Generally speaking, however, most mortgage loans in the US are recourse.  There are exceptions, such as purchase money mortgages in California and all 1-4 family residences in North Dakota, and various states limiting deficiencies if a creditor proceeds through a non-judicial foreclosure.  But in most states a deficiency judgment is possible. 

Second, Feldstein doesn?t seem to get the real value of recourse.  The fact that a loan is called ?recourse? doesn?t actually mean that it will be recourse in practice.  It?s costly and time consuming to persue deficiency judgments on foreclosures.  State property exemption laws often protect debtors? assets, and wage garnishment requires a debtor with a job and can take a long time given federal and state garnishment limitations.  And the debtor can always file for bankruptcy and get rid of the unsecured deficiency debt.  As a financial matter, recourse doesn?t have a whole lot of value, and lenders often do not pursue deficiency judgments. 

Instead, the primary value of recourse lending is as a threat.  But here?s the thing.  Most homeowners, if asked, would assume that their mortgage is recourse, regardless of whether it is or not.  Thus whatever in terrorem effect exists from recourse is already in place, regardless of whether or not it is legally enforceable.  (And the really sophisticated borrowers know that even if a loan is recourse, they can probably arrange a short sale in which the deficiency is forgiven.)  There really is no extra ?umph? to his proposal from making the loans non-recourse. 

Third, Feldstein points to Europe and says that Europe does not have a negative equity problem because loans there are recourse.  This statement is wrong in three ways:

(1) Feldstein has no idea what ?European? mortgage foreclosure law actually is (and neither do I) and whether deficiencies are actually pursued and what assets are available to satisfy them.  Feldstein hasn't even taken the first step of determing what the law is on paper, much less dug into what it is in practice.  Without knowing this, there?s simply no way to make the comparison responsibly. 

(2) The obvious explanation for why those European countries that do not have negative equity problems have avoided them has nothing to do with recourse.  It has to do with Europe?s generally much higher down-payment requirements that result in VERY low loan-to-value ratios that create a large equity cushion for lenders.  For example, Denmark and Italy limits LTV to 80% by law and LTV is typically 50% in those countries.  Poland is 70-80%.  The average LTV on UK loans originated in 2005 was 78%.  In Greece it must be less than 75%.  The standard in Germany is 73%. In Spain, LTV is 66.5% on average.  And in France, LTVs are typically 16%!!! 

(This data is from the European Mortgage Federation.  It?s not as precise as I would like, but it makes the point pretty starkly nonetheless.)  There are costs to requiring high LTV rates--first-time homebuyers are often older in Europe. 

(3) In those countries, like the UK, where some lenders have abandoned the basic rule of asset-based lending?ensuring a large equity cushion?there are negative equity problems. (See here and here, for UK negative equity problem.)  Recourse won?t do the trick unless it is part of a shift from asset-based to cashflow-based lending.   

I'm glad that Feldstein is thinking about the negative equity problem, but recourse is a red herring. 

Full post as published by Credit Slips on December 03, 2008 (boomark / email).