Preventing Foreclosures

Larry Summers offers another solution to avoid the macroeconomic risks associated with mounting home foreclosures. Rather than direct government intervention (as Alan Blinder advocates), he proposes changes in bankruptcy law to facilitate settlements between borrowers and lenders:

Prevent US foreclosures, by Lawrence Summers, Commentary, Financial Times: The American economic outlook remains highly uncertain. But macro­economic policy is now properly aligned... To the extent conditions ... permit, monetary and fiscal policy are appropriately poised to provide further stimulus.

Policy towards America’s failing housing sector is in a far less satisfactory state. All honest analysts accept that policies adopted so far ... have had only a marginal impact on what may be the most serious crisis in housing finance since the Depression.

It appears house prices are down by 5-10 per cent from their peak, with derivatives markets predicting further declines of about 20 per cent. Price falls of this magnitude are likely to mean ... more than 2m foreclosures ... over the next two years.

Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases.

What can public policy do? ...[W]hen the current owner is able and willing to pay more than the lender can get by foreclosing on a house, it makes no sense to go through with a foreclosure. Yet because of conflicts among lenders, legal uncertainties and concerns about encouraging defaults, there are grounds for fearing that wasteful and unnecessary foreclosures will take place on a large scale, hurting families, communities, the economy and the financial system.

How can this problem be addressed? ... Direct government intervention in mortgage markets risks creating delays, burdening taxpayers and inhibiting necessary adjustments in house prices.

The right focus is on measures that will prevent unnecessary foreclosures by facilitating more efficient settlements between homeowners and their creditors. Legal changes ... to bring ... family homes into conformity with general bankruptcy practice in two areas ... could make an important contribution.

First, remarkably, bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes.

Critics worry that such measures will dry up the supply of mortgage credit. This is a legitimate concern and the reason why legislation should be carefully and narrowly drafted... But it is worth noting that: some inhibition on lending to those who seem likely to go bankrupt might be a good thing..; and moreover, chapter 12 of the bankruptcy code ... applied these principles to family farms ... to resolve great financial distress without long-term costs in terms of reduced farm lending – despite protestations much like those that are heard today.

Second, methods need to be found to enable creditors who accept a writedown in the value of their claims to retain an interest in the future appreciation of the homes on which they have mortgages. This is standard practice in situations of corporate distress, where debt claims are partially replaced by equity claims. ...[I]t would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs.

Bankruptcy reform alone could, on some estimates, avert 500,000 foreclosures... As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans.

One quick response to comments on the Blinder post on recreating the Home Owners’ Loan Corporation as a means of limiting foreclosures (Brad DeLong comments briefly on the Blinder proposal here). My job as a macroeconomist is not to make moral judgments about who should be punished for their bad behavior. That's a job for someone else. My job is to stabilize the economy and do so in a way that does not harm economic growth over the long-run or lead to instabilities in the future due to bad incentives arising from the stabilization attempt.

Comments

[Keith]

"My job as a macroeconomist is not to make moral judgments about who should be punished for their bad behavior."

This contradicts the following:

"... or lead to instabilities in the future due to bad incentives arising from the stabilization attempt."

Inevitably, judgements about who should be punished have everything to do with instabilities in the future.

Ernst Fehr has shown that the ability to short sell makes markets more stable and less subject to collective irrationality.

So it makes sense that we have developed a moral sense about the fact that people should collect their marketplace rewards when they didn't foolishly follow the herd. That't part of making sure that the market stays rational.

There's also a strong reason to make sure that the people who are more capable of correct independent judgement and less susceptible to mass craze get their marketplace rewards. The marketplace yields the collectively rational outcomes when money flows to those people.

[Keith]

I might also add that if you aren't considering what the political process will do to your proposal, how the system will get gamed once you've allowed the government to take over mortgage liabilities, then I'm just not that excited.

Please let's consider robustness to the political process in the proposals.

I think one safe rule for policy robustness is that taxpayers don't eat any mortgage liabilities. That avoids a path-dependent process that's just too ugly for words.

The knee's jerkin' for a reason!

[Keith]

So Summer's proposal beats Blinder's, IMHO.

[James]

Larry Summers proposal, if I understand it correctly, is to smooth the way for a renegotiation of the mortgage liablility between the bank and borrower, to prevent an imminent foreclosure, He estimates that this would prevent about 500,000 foreclosures.

A good idea, to the extent that it does not allow extraneous tinkering with the bankruptcy laws to open holes in unrelated areas, which is always the problem when dealing with the current crew in Washington.

But one thing struck me in reading this. So far the housing downturn is relatively modest. A 10% correction is relatively par for the course in most 'bull markets', and a robust system should be able to take that in stride. An additional 20% is more of a problem, but we're not there yet.

The broad equity markets like the Russell 2000 recently corrected 20% since October 2008. No one seems particularly upset by that. Yet the housing market declines 10 percent, and we are ready to bring back the New Deal.

Just how imbalanced is our economy? Just how vulnerable is our financial system? I would suggest its much more vulnerable and much weaker and more distorted than most macroeconomists realize, being too busy looking at the trees to see the forest, too busy measuring photons to see what is illuminated.

Subrprime and CDOs are just the tip of the iceberg, a symptom of a much deeper problem. Take a look at the dominos a little further downstream like the CDS derivatives at a ratio of 40 or 100 to 1 against actual defaults covered, and tremble in despair.

Our financial system, the pride of our economy, is sick, imbalanced, and too far gone for further bandaids. The further we prolong the current structure, the worse its going to get when it finally comes to its final 'black swan event.'

Sorry to seem gloomy, but an astute observer can see this progression of events going back to the S&L crisis if not sooner, and the band plays on...

[Keith]

James makes a good point. In some ways, things like FNMA and the mortgage interest deduction have made it so our middle class has an overly large portion of its wealth tied up in housing.

The social effects of this are not wholly positive.

[Bruce Wilder]

MT: ". . .in a way that does not harm economic growth over the long-run or lead to instabilities in the future"

And, moral outrage has no part in providing the political motivation to do what needs to be done?

No Child Left Behind, Clear Skies, Healthy Forests, Financial Innovation

As long as we allow corrupt policy to hide behind facile PR, people are going to wonder what any proposal is all about. Brad DeLong does us the great favor of categorizing Blinder's proposal as what it is, bank nationalization.

A policy of mitigation should not be confused with a policy of reform. Federal supervision and regulation of banking failed. That problem will have to be fixed.

A policy of mitigation cannot "avoid" the harm that's been done. We cannot prevent a decline in housing prices. We can undo the insolvency of the banking system. We can face it, and decide, who will have to suck it up, in an orderly way.

These policy proposals, which are being floated, are part of the job of figuring out the size, scope and nature of the problem, which is to say, who will be screwed, and by how much.

The moral narratives are perfectly appropriate, as part of a discussion of who will be screwed, and by how much. Bank nationalization implies that the taxpayers will be left holding a large part of the bag, which, probably, more properly belongs to multimillionaire bank executives.

I hope that, as these proposals for mitigation, and others for regulatory reform, continue to float up, some of the discussion will focus on the extent to which the bank crisis was by design. Bankruptcy reform, as Summers proposes it, draws welcome attention to the execrable bankruptcy reform from a couple of years ago.

We are met on a great battlefield of class warfare. I am afraid I am not thinking we can trust the technocrats to lose the peace negotiations, as they lost the battle.

[Keith]

Following up on Bruce, the free market is delivering a pretty solid punishment for those investors and stockholders who went for the happy talk CEOs and salesmen.

The free market is also about to deliver less expensive homes for those consumers who saved and rented and didn't throw their money away because some huckster realtor gave them some happy talk.

The free market is delivering outcomes that are at least somewhat just and are certainly beneficial to society in terms of teaching important lessons that will make markets work better in the future, and giving money to people who are less susceptible to social pressure. Both of these generate better market outcomes.

I'm all for government proposals that improve on this, but government proposals that move liabilities to the taxpayer threaten to destroy all these virtues, and give us something a lot worse.

[ken melvin]

-"Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases."

Missed it by a mile.

[Keith]

We can talk about bringing back regulation all we want, but let's remember that the market is currently delivering the best regulation of all, nailing the foolish investors and stockholders, and homebuyers.

Let's not bring back the government regulation at the expense of this far superior free market regulation.

[mik]

...[W]hen the current owner is able and willing to pay more than the lender can get by foreclosing on a house, it makes no sense to go through with a foreclosure. Yet because of conflicts among lenders, legal uncertainties and concerns about encouraging defaults, there are grounds for fearing that wasteful and unnecessary foreclosures will take place on a large scale,

Sounds pretty good, but who is a lender?

In most cases mortgage is being serviced by some bank or such. Mortgage servicer does it on behalf of somebody else -- GNMA holders?

In last 20 years I did about 10 refinancings, residental and rental properties.
In all cases I first tried to talk to a mortg servicer. In all cases they were not that interested, the fact that they were going to loose my mortgage (mortgage will be paid) did not bother them at all.

So, why in the case of looming foreclosure, the mortgage servicer will be interested in doing something extra?

I just don't understand how it is supposed to work.

[Organic George]

Smothing out the markets is just prolonging the market adjustment.

What happened to the freedom to fail? Risk is the basis of all investments. Again the discussion is not about people stuck in overpriced homes. It's about the corruption of the financial system by greedy irresponsible people.

We have to deal with the 800 lb gorilla in the room. How do we punish the crooks, and re-regulate the banks and brokers so assure this does not happen again.

Why are these esteemed economist not talking about the corruption issues? It not a moral judgment it the future of the US financial system. This is the greatest opportunity since Brenton Woods to remake the US economy. This should be an economist dream, instead they are nobbling at the edges of a failed system.

If you are a Macro economist think BIG

[Partial Solution]

It's probably cheaper than the expensive foreclosure process. Reduce monthly payments to what the borrower can afford. When the home is sold, any capital gains go to the lender until the full nominal value of the loan is paid.

Of course, none of this will reassure foreign savers that their savings will be safe here, on which the "borrowing capacity in homes" ultimately rests. It Will be sending foreign savers the message that domestic savers long ago learned, that savers will not be paid back the full purchasing power of any money they lend out. Maybe they will keep saving and lending anyway, unlike domestic savers.

[RW]

The Calculated Risk blog is a good place to spend some time if one wishes to understand how a residential housing bubble can morph into a major credit and liquidity crisis. One thing that will become clear is that among a number of areas of regulatory failure there are a couple in particular that create a problem for solutions such as those proffered by Larry Summers: (1) Many mortgages are held in complex securities and it is not clear who a home owner would negotiate with (as noted above the loan servicers have no intrinsic interest), (2) a rather large but imprecisely known number of loans lack adequate documentation so actual lien ownership becomes problematic and additionally (3) a significant number of those loans may have been so poorly and/or fraudulently originated as to have been rendered virtually worthless; e.g., http://tinyurl.com/yr4nuz

[Winslow R.]

I don't think Brad's characterization of bank nationalization is correct. Loans would be purchased by the government then refinanced at a lower rate bailing out banks.

Where does the part about the government owning Citigroup come in?

I could just imagine Citigroup complaining about government competition for these upside down mortgages and demanding additional compensation.

Economists can't explain wealth inequality, yet their proposals for bank bailouts just add to the 'problem'. How soon you forget record Goldman bonuses? Where are those bonuses now when they are needed to recapitalize the financial sector.

Mark wrote: " My job is to stabilize the economy and do so in a way that does not harm economic growth over the long-run or lead to instabilities in the future due to bad incentives arising from the stabilization attempt."

Economists have failed in this regard by failing to identify over-leverage as the basis of instability and the 'problem' to be solved. Your proposal just shifts the most egregious part of the over-leverage onto the government. It does not reduce the ability to over-leverage again.

Your statement does not jive with your proposal.

[Jay]

"It's probably cheaper than the expensive foreclosure process. Reduce monthly payments to what the borrower can afford. When the home is sold, any capital gains go to the lender until the full nominal value of the loan is paid."

Partial Solution was an apt name for this partial analysis. No mention of the NPV of the future costs that arise because we keep teaching Pavlov's dog that it can rely on bailouts.

[Partial Solution]

If potential home buyers know that they take absolutely no risk if they overpay, then they will have no motivation to avoid over bidding using other people's money (subsidized loans). You have a point.

[save_the_rustbelt]

Perhaps he is just trying to be brief, but I'm not certain Summers understands bankruptcy law, and is sounds as if he doesn't understand that the business chapters and personal chapters are different.

Many foreclosures are state common pleas cases and most have nothing to do with bankruptcy procedures, although sometimes both occur. I'm confused Larry.

At any rate, any bank can negotiate a settlement with any foreclosure owner any time until the gavel drops, this has always been the case.

Banks are incredibly inflexible stupid bureaucracies, in which people are losing other people's money so it is not too personal (except to the people losing their homes).

Once the case gets to the lawyers it is all over, they could give a damn about what makes economic sense.

Summers is right about one thing, banks are INCREASING the losses by rapid foreclosures, especially in a market with slim sales prospects. Better leave the house occupied, insured and secured.

[Partial Solution]

Rust..."Better leave the house occupied, insured and secured."

Yes. The law enforcement agencies in many cities seem to be completely incapable of protecting unoccupied homes. I was amazed at a newscast of a man carting pipes away from an unoccupied home in a shopping cart. The news crew filmed him doing it, but no police were around. Entire rows of homes have been gutted in some neighborhoods. This is an absolutely incredible breakdown of law and order. Given the reality of the situation, banks would be better off just leaving someone there to protect the place, and hope to make up the difference down the road when the home eventually sells.

The borrower should not be allowed to profit from any future sales, until the loan has been paid off in full (including agreed upon interest). However, in the absence of an effective police force in some neighborhoods, leaving borrowers in the home to protect it may be the best option. Even if the borrower pays only a fraction of the agreed upon payment.

[Partial Solution]

Of course, the root of the problem in cities like Cleveland is the high prices that homes were bid up to. The average home has a useful life of about 75 years. Most of the relatively small homes in Cleveland were built in the 1950's, or earlier. 2/3 of their useful lives were gone, and many of the homes need expensive repairs. However, they sold for prices that were only justified if they were brand new. If the homes had sold for about 50k or so, people could have afforded them, and would still be living in them. Bidding the price of aging homes up regardless of how close they are coming to the end of their useful lives makes no economic sense.

The system is in need of a reality check.

[groucho]

Important stuff from Brad Setser's blog:

"The "effective nationalization" of US housing credit that BNP Paribas' Richard Iley identified earlier this year and John Cassidy highlighted in Portfolio goes even deeper. It isn't just that the Federal Home Loan Banks are supplying credit to a host of US financial institutions. Or even that the Agencies increased both their debt issuance and their purchases of mortgages late last year. Or that there are calls for a Federal Homeowner Preservation Corporation to take dud mortgages out of private hands. It is also that the Agencies are raising a lot of the money that they effectively lend to US households from central banks.

It is de facto nationalization on a global scale,

with foreign central banks serving as the ultimate creditors and the US government and various US government agencies and government-sponsored-enterprises serving as an intermediary between central banks looking for safe assets and the credit risk associated with the US mortgage market."

As they say "follow the money". What Summers and Blinder propose is window dressing. The "meat and potatoes" will be determined by how the trade imbalance reserves are recycled and to whom.

[Peter Schaeffer]

This is very good idea, at least compared to the other turkeys. It was also the law of the land until the late 1970s. Historically, Federal bankruptcy courts did have the power to change mortgage contracts. This authority was removed at the behest of the mortgage industry.

The sky didn't fall back then. It won't fall now, if the pre-late 70s rules are restored.

Of course, Summers’s ideas won’t appeal to everyone. It isn’t clear how Wall Street will benefit from his scheme.

[Partial Solution]

"...with foreign central banks serving as the ultimate creditors..."

Many foreign state banks are in desperate situations because they made too many US mortgage loans (indirectly). The German state banks are on the verge of collapse.

Spiegel Article

Since we don't have any significant domestic savings in a form that can be recycled into mortgages, a solution involving future use of foreign savings will need to reassure foreign savers.

[peterbob]

I'm trying to think of the characteristics of government intervention that serve to keep credit flowing. The main danger, as I see it, is that markets (for housing, loans, etc.) become stuck and transactions plummet. I have no interest in protecting investors or people who bought houses from realize large losses.

So some characteristics include:

1. Hasten price discovery (drops) in housing markets so that buyers once again become willing to buy.

2. Keep credit available to borrowers who are a good risk. This includes borrowers for houses and businesses.

Government bailout plans that keep prices from adjusting do not serve the economy well. And it would seem that "light must be shed" on the true value of MBSs, CDOs, etc.

[Partial Solution]

"Government bailout plans that keep prices from adjusting do not serve the economy well."

No they don't, but home owners are a politically powerful group. Most of them are irate at falling prices, and are demanding that officials "so something" to make prices go up. Local gov is also demanding similar action so they can take in more property taxes.

Since prices in many areas are already unsustainably high, and foreign lenders have had enough, this creates an interesting political problem.

[bullbust]

I'm going to simply repost Cranky's comment to the cited Delong blogpost.

As an ordinary, everyday works-for-his-money taxpayer (not working class, but that is where I started too), the only way I could see this even being a gleam in Congress' eye is if every single dollar in bonus, and salary above $125,000/yr, paid to every single executive in the financial industry since 1998, is clawed back first. Otherwise all that we would have is the mother of all moral hazards, except this time with real weapons of mass destruction. It would be an open invitation for the financial industry to loot and, let's be honest, enslave every working person in the United States forever.

Cranky

[prostratedragon]

(1) Many mortgages are held in complex securities and it is not clear who a home owner would negotiate with (as noted above the loan servicers have no intrinsic interest)

Within the last few days Tanta at CalculatedRisk blog has discussed proposals that closely resemble both the Bllinder and the Summers proposals. The fact of securitized loans is at least as great a stumbling block for the Blinder/buyout proposal (see also the comments) as it is for the Summers/cramdown proposal (same), at least for the broader question of maintaining the loans of which the FedGov would be the new proud owner, if not for completing the initial transaction:

I have visions of FHA getting saddled with all those sorry piles of lost note affidavits, missing assignments, title encumbrances, and general servicing/custodial failures. It wouldn't much matter what the bid price was if nobody does the due dilly to determine just how much of a chance there might be to convey title/foreclose on this stuff if the goverment had to.

As she treats in more detail in some earlier posts that I can't find right now, this is partly because servicers sometimes have authority in standard service agreements to make loan modifications with delinquent borrowers for the purpose of keeping the loan in the pool; this might not be true of all loan pools, and it might be open to interpretation as to what interventions consititute a tax-disqualifying level of "management," but it is at least sometimes possible right now without violating any contract. As to finding where a given loan is, well, people who keep up their paperwork ought to be equal to that task, eh? And as noted, those files eventually would have to be found anyway.

[a]

"My job is to stabilize the economy..."

Isn't there just a bit of arrogance in this comment? You are supposing that you *can* stabilize the economy. Maybe you can't; maybe Americans are going to get a lot poorer, and the only question is which ones get poorer the most. After all, Americans don't save any more, and many of them have taken paper housing profits (2-4 trillion dollars of it) and spent it on "home improvements" and large cars and vacations. How are you going to conjure up wealth that does not exist, in a nation that does not know how to live within its means?

So my worry is that your "stabilization" of the economy will do no such thing. It will simply throw good money after bad, and make whole individuals and institutions who should go bankrupt. Prove me wrong.

[ken melvin]

Seems that the money is already lost and the question is now who gets stuck. I submit that the only logical answer is that it be they who lost the money, i.e., the lenders.

[groucho]

"I was amazed at a newscast of a man carting pipes away from an unoccupied home in a shopping cart. The news crew filmed him doing it, but no police were around. Entire rows of homes have been gutted in some neighborhoods."

Partial, that's called recycling! At least those homes aren't completely "dead weight". A thriving home recycling economy can be created(just as the auto industry) by allowing enterprising individuals to scrap for profit.

A couple of years ago I wrote a short piece called HUD 2.

Housing and Urban Destruction.

Can't find it in my files. Basically, it was about rehiring every worker that built the homes and hire them to dismantle them piece by piece with each trade required to dismantle whatever work they had done. Demolition experts would be hired to take down concrete structures.

[Worker]

Summers proposal is the best so far- it helps long term homeowners with liquidity without subsidizing stupid decisions by borrowers and lenders.

1. restructure their payments while
2. protecting the rights of lenders to maximize their recovery and
3. preventing taxpayers from directly absorbing liabilities from either party.

I would say even with taxpayer subsidies/ bailouts, negative equity certificates should be used to fund the subsidy.

People who support "cramdown" changes should also support the idea of negative equity certificates or similar participation rights in the upside of the investment.
Equity holders in business investements aren't able to eliminate secured debt while also keeping their equity interest.

[Bruce Wilder]

Keith: "Let's not bring back the government regulation at the expense of this far superior free market regulation."

You should get that embroidered on pillows, and sell the pillows at the University of Chicago souvenir shoppe.

[Partial Solution]

"...it was about rehiring every worker that built the homes and hire them to dismantle them..."

There is strong demand for low cost housing, and dismantling homes is not the way to meet this demand. Homeless people are moving into abandoned homes, and many less well to do would love to buy the homes if only they were offered at an affordable price (to them). Offer the homes for 50k or so, get rid of the regressive property tax, and the less affluent people of large cities would finally have a place of their own.

[groucho]

Partial, my HUD 2 proposal was totally "tongue in cheek". That said, their was an interesting(and rather expensive) build out of a Nuclear power plant here on Long Island.
Shoreham Nuclear Power Plant, built and then decommissioned without ever producing any power for only $6 Billion.

Same workers that built it, took it apart. Nice career, 2 or 3 of those and you're done.

[Foreclosure Questions]

You wonder just how ugly this thing is going to get.