“Foreclosuregate” risks becoming a quagmire

LAS VEGAS, AS A CITY, WINDS DOWN OVER THE NEXT TEN YEARS
OCTOBER 21, 2010: Vegas may be a very dry place but nowhere else in the country are more homeowners “under water”, owing more on their mortgages than their homes are worth. Las Vegas prices have fallen by up to 70% from their peak; more than half the mortgages in Arizona and Nevada are in negative equity.

Since lenders bear the brunt of the higher losses that foreclosure entails, their general reluctance to modify the balance of mortgage loans is puzzling. If mortgages could be written down to a value above the likely foreclosure sale price, that would generate benefits for both creditor and borrower. Yet a report earlier this year into the government’s foreclosure-prevention program showed that principal was forgiven in only 2% of cases. So what is preventing a better outcome?

WRITING PRINCIPAL DOWN WILL NOT HAPPEN

Loan servicers, which manage loans on behalf of investors in mortgage-backed securities, may fear lawsuits alleging that borrowers have been treated too generously. Writing down loan values often affects more than one lender—second, third and even fourth mortgages were common during the housing boom. Banks are wary of moral hazard: if word spreads, borrowers with the ability to pay their mortgage may deliberately miss payments in order to get their loans adjusted.

CRAMDOWNS WILL NOT HAPPEN

A measure called lien-stripping, or, more commonly, “cramdown”, offers another way around the securitisation bottleneck. This would tweak the existing bankruptcy provision known as Chapter 13 to allow judges to write down the value of a primary mortgage. Cramdown is already allowed for other forms of consumer debt, such as mortgages on holiday homes. Research examining the impact of cramdown on agricultural loans found that banks usually got more than foreclosure value on reorganised loans, and that interest rates scarcely rose. At the same time the possibility of a principal write-down in bankruptcy made banks more willing to negotiate reductions pre-emptively.

RIGHT TO RENT WILL NOT HAPPEN

More ambitious still is the “right to rent” program. Under that program The lender would give defaulting borrowers the option to rent their homes at market rates. The bank would obtain the whole of the equity stake in the house; with rental income still flowing in, sale of the property could be delayed until markets were healthier. Critics point out that property management is not a core skill of banks, but the job could be outsourced.

GOVERNMENT SUBSIDIES WILL NOT HAPPEN

There is another way. In the 1990s Mexico cleaned up its debt crisis by offering large government subsidies, of up to 60% of a loan’s book value, to help pay down borrowers’ debts. Such a programme would not come cheap—America has some $766 billion in negative-equity debt—but it would have the distinct advantage of simplicity.

FULL SPEED AHEAD INTO THE REEF

The unfortunate truth is that there are no nice options left. Large-scale voluntary write-downs look unlikely—they surely would have happened by now. That leaves a choice between twisting lenders’ arms, throwing public money at the issue, or letting the waters close over people’s heads.

If you let one person off paying what he owes, then surely his neighbour will want the same? Also, many homes have several claims or “liens” on them, which complicate any debt reduction. And lenders fear lawsuits from mortgage bondholders if they start writing down loan values. These are reasonable worries. How might government encourage a better outcome?

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