A terrible housing idea

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Today Obama is expected to announce his proposal to prop up the beleaguered housing market later today. An article in the Washington Post this morning discusses several potential components of the plan, some of which (interest rate reductions, workout incentives) are good ideas. One piece that should not be included, however, is a provision for bankruptcy cram downs.

Cram downs would allow bankruptcy judges to reduce the outstanding principal on mortgages for homeowners filing for bankruptcy. This is what judges already do for many types of debt (loans to buy cars, yachts, vacation ski lodges) during bankruptcy proceedings. But primary residence mortgages have historically been outside the purview of bankruptcy debt reductions in order to keep mortgage rates low. The reason for that is simple: if lenders knew bankruptcy judges might reduce the principal owed, they would charge higher mortgage spreads to compensate for that risk. But some Democrats like the idea of cram-down provisions and have been frustrated by Obama's reluctance to embrace them.

But the fundamental risk of cram down provisions -- that mortgage rates would rise as a result -- is still relevant, however, and the last thing we need in an ailing housing market is an increase in mortgage rates. Furthermore, cram-down provisions create moral hazard by making bankruptcy relatively more appealing (emphasis on "relatively," as the Dems are quick to point out that nobody likes declaring bankruptcy) and thereby might clog bankruptcy courts with underwater mortgages that could be better dealt with through a standardized loan modification process.

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Benjamin Lockwood

Benjamin Lockwood is a researcher at Columbia University Business School.
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