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.