What's the matter with mortgage cramdowns?

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Why not make the cheeky bastards who run banks pay for their mistakes?

Axiom:  There Ain't No Such Thing As A Free Lunch.  If you make the bankers pay, they will make you pay.


There is a school of thought that says that it is wise to do the cramdowns pour encourager les autres:  if bankers fear having their loans written down to the market price of the house, they will be more careful about lending.  It's best exemplified by the sadly late Tanta at Calculated Risk:

In fact, I have some sympathy with the view that mortgage lenders "perform a valuable social service through their loans." That's why, when they stop doing that and become predators, equity strippers, and bubble-blowers instead of valuable social service providers, I like seeing BK judges slap them around. Everybody talks a lot about moral hazard, and the reality is that you're a lot less likely to put a borrower with a weak credit history, whose income you did not verify and whose debt ratios are absurd, into a 100% financed home purchase loan on terms that are "affordable" only for a year or two, if you face having that loan restructured in Chapter 13. If you are aware that your mortgage loan can be crammed down, I'm here to tell you that you will certainly not "forget" to model negative HPA in your ratings models, and will probably pay more than a few seconds' attention to your appraisals. You might even decide that, if a loan does get into trouble, you're better off working it out yourself, via forbearance or modification or short sale, rather than hanging tough and letting the BK judge tell you what you'll accept. That would be a major bummer, right?

There is something to this line of thought.  But only a little something.  Her proposal has a lot of problems.

For one thing, some of the premises on which it seems to be based--like that bankruptcy generally results in the loss of the house--are, as far as I know, simply incorrect.  Bankruptcy is usually undertaken to make it easier to keep the house by shedding unsecured debt:  distressed homeowners are often choosing between bankruptcy and foreclosure.  A study from Delaware, the most notoriously creditor-friendly state in the nation (unsurprising, given how much of its political economy has been driven by credit-card companies), shows that most homeowners still owned their homes years after filing.  Since most bankruptcy filings are Chapter 7, her premise that it's generally not possible to keep the house in liquidation is false.  Of course, that may be different now, but I suspect that the choice between foreclosure and bankrupty remains; it's just that more people are probably choosing foreclosure these days.

Second, the idea that this will benefit bankers by stopping foreclosures can be, at best, only weakly true.  To the extent that there really is a massive downward spiral in a neighborhood driven by foreclosure sales, yes, this might help by stopping the flood of sales.  But that's only part of the problem banks face.  There's a broad market depression driven by changing expectations, risk appetite, and credit availability.

Against the benefits of being stuck with homes in neighborhoods blighted by foreclosures, you have to set the costs the banks will bear.  If you allow bankruptcy judges to hand people loan modifications of 10% or more of face, you will get all the people who would have been foreclosed upon declaring bankruptcy, plus a lot more.  So instead of writing down the value of, say, a million homes in foreclosure, you suddenly write down the value of three million in bankruptcy.  This will further impair bank balance sheets, contracting the credit market still further.  Among other things, what that means is fewer mortgages extended, and thus, another fall in home demand.

Moreover, he administrative costs of workouts are very high.  It is commonly noted that foreclosures can cost a bank 50% of the value of the property.  Well, once you've added the cramdown to the administrative overhead of dealing with the bankruptcy court, cramdowns don't look so hot either.  And as we noted above, you're going to get a lot of extra people applying for that cramdown bonus, meaning that the cramdown might cost the banks substantially more in overhead and loss of loan book value.

Besides, as noted elsewhere, a substantial fraction of loan workouts don't work; a cramdown is just a variation on a workout.  So in a large number of cases, after all the tsuris, the bank is going to foreclose anyway.  Costing them whatever it was going to cost them before.

Then there are the social worries, even beyond kicking weak banks while they're down.  The cramdowns may simply delay the inevitable, dragging out the crisis for years while those who can't realistically afford their homes inch towards default.  Consider two things I haven't seen much written about:  

1)  After you declare bankruptcy, you can't do it again for several years
2)  Market prices may not have bottomed

The early adopters of save-the-house bankruptcy may well end up with both a bankruptcy and a foreclosure on their credit histories.  Unlike foreclosure, which mostly occurs on non-recourse loans (the lender can't go after you for more than the value of the house), bankruptcy requires that you have basically zero assets (beyond protected things like the car you drive to work and the house you live in).  People in bankruptcy also can't discharge a number of debts--child support, alimony, taxes, student loans.  There is no way around the fact that you've got a bunch of financially fragile people who are very vulnerable to a job loss or unexpected emergency, which means that some of them are going to fall behind on their house payments even on lower principle.  If they took bankruptcy early, they will be upside-down on a mortgage that they can't discharge.  Hello, foreclosure.  Yes, you might say, but they would have faced foreclosure anyway!  Ah, yes they would . . . but they wouldn't have the bankruptcy knocking another two hundred points off their credit score.

Finally, let's think about the effect on future loans.  Tanta et. al. think it will be salutary, because banks will lend to fewer marginal people.  Indeed they will.  They will also charge everyone else higher rates to compensate for the risk of falling home prices.  Want to know why your car loan costs so much more than your house loan?  One, cars depreciate faster, two, they're easier to hide from the repo man . . . and three, after 2.5 years, the value of the loan can be written down in bankruptcy.  

Most perniciously, factoring in the risk of house price depreciation will not focus bankers on whether lenders can make their payments; it will focus them on whether the neighborhood is likely to appreciate.  Bankers will strenuously attempt to avoid lending into "marginal" neighborhoods, which is where, any real estate agent will tell you, prices fall farthest during a bust.  That means some exurbs, and a whole lot of cities.  The more they factor in home price risk, the less your qualities as a buyer matter--ultra-responsible yuppies buying in a gentrifying neighborhood still look like an awful risk if you know that house prices might fall, and your principal might at any time be written down by 10%. And, of course, that's a self-fulfilling prophecy--if banks won't lend on houses that have recently spiked in value, the value of those houses will fall back to the level where banks will lend.  

 It's hard, in fact, to imagine a deliberate policy that could more effectively halt the urban renaissance that has taken place in neighborhoods like mine.  Subsidized crack in schools, maybe.

It's not that I feel sorry for the bankers, who, like their riskier borrowers, thought that they had found a simple formula for making money without working.  Nor am I particularly worried about a policy that cuts into their greens fees.  But I do not like complicated policies designed to disguise the costs of something.  If you want to take money from banks, levy a tax on banks.  If you want to bail out homeowners, put it in the budget.  We will not get through this crisis by moving the massive losses in the housing market around to different balance sheets so that the numbers don't look so scary big.  It's time to man up and take a true accounting.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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