Bankruptcy

WSJ: The Tail Wags the Foreclosure Dog

By Adam Levitin

The Wall Street Journal's economics blog had a poorly thought-through take on foreclosures. The main point of the piece was that the time from default to foreclosure has grown much, much longer. (Not noted is that the timeframe varies significantly by state).  The piece has scant analysis, but it's conclusion is that longer times to foreclosure makes strategic default more attractive as in lengthens the time a home-owner can remain in the home and consume housing for free.  The blog concludes that therefore we need to speed up foreclosures. 

This really gets the strategic default problem backwards. It has the tail wagging the dog. The problem is that the homes are underwater, not that foreclosures are taking too long, and strategic default actually plays a very important role in market clearing on housing prices.

If homes weren't underwater, the time to foreclosure matter very much.  Indeed, even when a home is underwater, I'm quite skeptical that the marginal difference in time to foreclosure from say 244 to 492 days is actually swaying anyone's decision to default. The WSJ piece certainly doesn't present any evidence that it matters, and given that there's so much more wrapped up in the decision to default, that another average 8 months rent free is unlikely to make the difference in most cases (not least because homeowners don't know how long they themselves will get rent free).

It's nothing new to see the WSJ favor free market economics...until the market gores the WSJ's pet oxen. But I would posit that from a free market perspective, strategic defaulters aren't a bunch of deadbeats, who are "stiffing the bank."  Instead, they are the heroic invisible hand of the market that is forcing housing prices to clear at their market value, rather than at a morally-inflated value. A more technical way of saying that homeowners are "stiffing the bank" is that homeowners are "exercising their mortgage put option." I'm sure no one would say that a bank was stiffing its counterparty if it exercised an in-the-money put option.  That would be called smart business.

Clearly there is a double standard between business and consumer credit. We've seen this with cramdown, we've seen this with BAPCPA, we've seen it elsewhere. Clearly there are differences between businesses and consumers, and they should be taken into account in the law, but if one truly believes in the market, one wants to see options exercised when they are in the money. That's part of how prices to clear at the market level. But who ever said that the WSJ actually believed in the market? 

Full post as published by Credit Slips on November 28, 2010 (boomark / email).