Thursday, October 13, 2011

Absorbing Mortgage Debt

Martin Feldstein puts forward a proposal to have the Government and the Banks absorb excess mortgage debt, so the economy can "get on with it."  In principal, this seems like a good idea.  In the details of the proposal, I don't get it, as I will illustrate.  It seems to me an even more radical solution is necessary.

How many of us know the current "value" of our homes?   Here, I would define value as what one could get in resale now if one put the house on the market.  Most of us know what we paid for the house initially, and certainly we know the value of our mortgages, but the banks tell us that.  I know that when we last refinanced, less than a year ago if I recall correctly, we did not require an appraisal.  It was the first time I can remember getting a mortgage without one.  My point here on this is nobody wants to know the value of the home, for fear it is lower than what we hope it is.   Literally, no news is good news.

Let me abstract from that issue in what I say below, but I do want to note that there can be substantial moral hazard in the proposal given this uncertainty about home values.  Borrowers who might be able to reduce the principal on their mortgage have incentive to understate the value.  Banks, in contrast, have incentive to overstate home value, so they don't have to absorb debt.

In my lifetime I've purchased 3 homes - a condo I had when I was single, our renovated Victorian house on Old Church Road that we sold about seven years ago, and the one we live in now.  Each time the mortgage was 80% of the purchase price.  For the Old Church Road house, for a time we did have a home equity line, justified in my head by taking advantage of the mortgage interest deduction (and perhaps on the capital gain we took as we did put a fair amount of bucks into the house and when we resold it, there was a significant capital gain).  But we really never leveraged ourselves beyond the 80%.

In Feldstein's proposal he wants to reduce the mortgage principal to 110% of value. I don't understand that.  In the piece Feldstein distinguishes between a nonrecourse loan - if the borrower defaults the lender can repossess the house but is not entitled to other assets of the borrower, most mortgages are in this category - and a recourse loan which he suggests is what the converted mortgages should be.  Perhaps this makes sense if you assume the borrowers will find a decent job soon thereafter and the value of the home will rise, both as a consequence of the program.  But if the economy continues to tank for a while, Feldstein's program notwithstanding, you can have these borrowers now with recourse loans, therefore less incentive to look for work, and the loan even after it has adjusted, might still exceed 110% of value, if housing prices fall further because the program is perceived as inadequate and the market treats the program as the last straw.

It seems to me you need to keep the mortgages as nonrecourse and reduce principal on them to less than 100%, say 90%.  This makes the pill to swallow much bigger for the banks and the tax payers.  But it seems to me it also makes it much more likely that such a program would be effective. 

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