More on mortgage cramdowns

By Megan McArdle

Some of the issues that were raised in the comments to my last post on mortgage cramdowns:

1.  They will force the banks to write down the housing assets backing the mortgages to fair market value.  Well, not quite.  They will force the banks to write down the assets backing the mortgages to what a bankruptcy judge thinks is fair market value.  Many of these assets are in illiquid markets where there is not currently enough turnover to assess the market value of the home.  If you assume that we are in the acute phase of a crunch, and that liquidity will eventually return, you are giving bankruptcy judges a lot of leeway to write down the house to whatever the debtor can afford--with the debtor getting the upside if he sells at a better price.

2.  But my car loan doesn't cost more than a housing loan!  If you've got good credit, true dat--but your car loan is for 3-5 years.  You pay extra for long fixed money.

3.  The whole point of bankruptcy is to keep concerns going rather than shut them down!  This is relevant to business law, but not so much to consumer bankruptcy, where we do not shoot consumers who cannot make their house payments and sell their estate to pay off the creditors.  The point of consumer bankruptcy is to recognize the fact that people do not have the income to meet their current obligations, and have no reasonable hope of acquiring enough scratch to do so.  Bankruptcy is an orderly wind-down of those obligations so as to fairly whatever the consumer can spare to the creditors.

Secured debt carries lower interest rates than credit cards precisely because it's, y'know, secured.  Specifically, banks offered lower mortgage rates because they knew that their mortgages could not be written down in bankruptcy.  (To be fair, they also didn't think that prices were going to fall much.)  Now consumer advocates want to rewrite the rules in the middle of the game to benefit consumers who got in over their heads.  They screamed bloody murder when the credit card companies got Congress to give them the same sort of gift in 2005, and with good reason.  But this is a much, much larger unilateral gift than MBNA got during the bankruptcy reform, which didn't actually make bankruptcy all that difficult to get for individuals--a slightly more expensive pain in the ass, yes, but not this kind of massive transfer.

4.  We're just returning to the pre-1978 standard!  But pre-1978, consumer bankruptcy was harder to get, and therefore played a much smaller role in our credit markets.  There have been a lot of changes to the bankruptcy code since then--you can't make one change and say we're just returning to the good old days of 1977.  To note one enormous disparity, consumer bankruptcy was very rare in 1977, for a lot of reasons, including the fact that inflation had ensured that people didn't end up underwater on their mortgages, and of course that unsecured credit was relatively uncommon.  

5.  What we need is  a slap in the face from reality:  recognize all the losses at once and get it over with.  

Three problems with this:

  • The markets are, as noted above, often illiquid, meaning we don't know what the houses are worth.  There's a substantial risk we'll overshoot on the downside--which means a lot of banks with unnecessarily impaired balance sheets.
  • This is a better argument for marking to market than for arbitrarily writing down the mortgages of anyone who's willing to declare bankruptcy
  • The administrative costs of this are very, very high.  Houses are the farthest thing from a commodity; figuring out what each of them might be worth is time consuming.  Doing it in the middle of a bankruptcy proceeding is even more expensive--you're negotiating with a judge, the bankrupt, and any other creditors.

6.  As Tanta says, this will encourage lenders to be more careful in the future.   Several issues with this:

  • It's not clear to me how well this would have worked during the bubble--a cramdown is irrelevant if you don't think that prices are ever going to fall
  • I don't think that we need to worry that lenders in the immediate future are going to ignore the possibility of house price depreciation.  It's not like they enjoy foreclosing on underwater mortgages.
  • How they worry matters a lot.  If they require solid downpayments, great.  If they decide not to lend in areas with house price volatility, it's much more problematic.  And if they panic and overprice a risk that they haven't faced in forty or fifty years . . . well, that's going to push down prices further in a lot of areas, setting off a further cycle of cramdowns.  Feedback effects matter.

7.  We shouldn't be forced to pay for your urban renaissance!  Fair enough--but that's not what we're talking about.  Right now, buyers in marginal urban areas pay, by bearing a greater risk of price depreciation.  With the cramdown, some of those buyers get a great deal, a lot of future buyers in those areas get stiffed, and probably everyone gets to pay higher rates to insure against price risk.

8.  Cramdowns give homeowners skin in the game (since their future payments build equity) and may help halt the cycle of foreclosure sales. At the same time, it does make irresponsible borrowing somewhat costly, rather than simply rewarding profligacy. 

I think this is true, and the best argument in favor of them.  I also think the costs outweigh the benefits:  whacking already fragile banks, giving homeowners who won't give up their homes in foreclosure incentives to declare bankruptcy, and all the associated overhead of same.  I think there are better ways to do this--have the government guarantee a stop loss on foreclosure prices, say.  More fundamentally, I don't think this is why most people are supporting them--they view it as a "free" way to give a lot of money to homeowners.  That means that whatever reform we get is likely to be bad.

9.  Oh, it's just FINE when your rich banker friends get a giveaway from the bankruptcy reform, but when HOMEOWNERS are getting one, suddenly you think it was a bad idea!

Check your assumptions, friend--I opposed the bankruptcy reform both at The Economist and my own blog on the sensible grounds that, first, it was changing the rules on borrowers in the middle of the game, second, easy bankruptcy was good for the economy, and third, there was no evidence that credit was too expensive or difficult to get.

If you want to reverse some of the bankruptcy reforms, I can name a number of good places to start--but rewriting the terms under which every mortgage in the country was written is not one of them.

10.  Why is it bad that marginal people aren't getting easy money?  It's not, exactly--but again, the devil is in the details.  We don't want banks to lend irresponsibly--but we want them to pay more attention to ability to pay and sound lending practices, not redlining.

11.  If Tanta were here, she'd wipe the floor with you!  Maybe--I can't tell.  She was certainly a formidable intellect.  But her factual claims about bankruptcy, for which she offered no evidence, were, as far as I can tell, simply incorrect.  They go against both the available studies, and what I repeatedly heard from bankruptcy experts when I was working on the issue--though of course, mortgages simply weren't a major issue in 2005.

12.  We only give debt special bankruptcy exemptions for good and just public policy reasons.  Why should housing be among them?

Because housing is treated specially by bankruptcy law.  Houses are among the items that cannot be seized and sold to satisfy creditors (in most cases), even if they are unencumbered. This is certainly more justifiable than the student loan exemption, which only exists because Uncle Sam refuses to stand in line with other creditors.  Arguably, it makes student loans cheaper--but it seems at least as desireable to make housing loans cheaper, since more people use them.

13.  It must be possible to have a mortgage market with cramdown risk, since we did for a long time.  Yes, we did.  But the housing market is already contracting rapidly.  Making demand contract further and faster is not exactly helpful.  I mean, it's good for me, because I have okay credit and don't own a home.  But I'm a minority.

14.  How high can the administrative costs of a cramdown really be?  Well, you've got a very lengthy legal process that involves a lot of negotiation over an asset with no fixed market price.  It will be shockingly high for the same reason that foreclosure costs are.

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