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Solving the Foreclosure Problem

There is no shortage of ideas about the current foreclsoure problem, but unfortunately very little progress in Washington. The problem is that an unusually large number of homes, and I will stick to residential mortgages in this post, are "underwater," meaning that the outstanding balance exceeds the apparent, current value of the property. Homeowners are thus tempted to "walk away" from the property, and abandoned properties lose value when they are not maintained. Moreover, there is a perception that the banks would often be willing to renegotiate the mortgages, because they are currently not in much of a position to foreclose and resell at a "profit," but ownership and credit claims on the property are dispersed in a way that makes renegotiation difficult. Nearly everything in this paragraph requires modification, argument, and upending, but I will focus on a mere few items here.

How can homeowners walk away when they are in debt?  In some jurisdictions, home mortgages are indeed non-recourse loans, so that the mortgage holder cannot go after the borrower personally. but in other places the problem is simply a practical one compounded by legal regulation. There are many protections against foreclosure, in part because there are often sad stories associated with past abuses. In many places it is estimated that it takes 18 months to eject a homeowner and sell the property in a way that yields a clean title. The home can suffer serious damage in 18 months. Moreover, many of these borrowers do not have much in the way of other assets or earnings, especially in the current economic climate. For some, that is why they have fallen behind on their payments.

One easy observation is that when we are out of this mess, home mortgage lenders will likely require much more in the way of downpayments, or equity cushions. If there is much of a bailout, then law may require this margin of safety - or barrier to optimistic home purchases -- in order to avoid a repeat, where prices decline and many owners are underwater.

But what might we do now to encourage cooperation between the residents and creditors of the property? Why not a buyout by the government in the form of a provisional forgiveness, or deferral, of a fraction of the mortgage in return for future payments in the event that income rises? Imagine for example a property bought a few years ago for 300 with a mortgage of 250 and a current property value of about 200. The homeowner no longer cares much about the property, though she might like to live in it. The chance of maintaining it and selling it for more than 250 now seems remote. But imagine that the mortgage is reduced to 125, half its value - though this fraction could be adjusted by decreases experienced in that region or zip-code. The homeowner and the creditors now know how to interact with one another, except that all payments are divided in half. In order to prevent moral hazard and not reward "bad borrowers" rather than responsible ones, the homeowner in our example would still owe 125, but the debt would now take the form of, say, 5% higher tax rates for the next ten years, or until the debt is paid off. If the homeowner is impoverished, there may be no "tax" payments of this kind, but then of course that homeowner may be unable to make the smaller mortgage payments too. Still, there will be no incentive to let the house fall in value. Without going into the particulars of the example here, the essential idea is that the loan is refinanced by the government, but the government can build in substantial deferral and possible forgiveness in order to make this attractive to the homeowner/taxpayer.   

How much should the banks get in this deal? One possibility is to promise the creditors everything the government eventually collects. In this plan, the government would be promising the most senior sort of security in return for a current debt that takes most foreclosures off the table. In another version the government fixes a percentage of the reduced debt and offers that to the banks (though here the collective action problem among banks comes into play). Either way, the overall idea is solve  the problems associated with underwater homeowners who would actually be willing to stay and pay "rent" or mortgage payments in amounts that are attractive to the creditors on a forward-going basis.

Full post as published by The University of Chicago Law School Faculty Blog on March 20, 2009 (boomark / email).