Renting Instead of Foreclosing

Yesterday, I explained some reasons why a mortgage payment deferral plan for unemployed homeowners troubled me. Reuters reports yet another plan being considered by the Obama administration. This plan would have distressed homeowners rent their houses, rather than foreclose. As the administration continues throwing ideas at the wall, will this one stick? I doubt it.

As with the deferral plan, the Obama administration is in the position of almost certainly having banks and investors balk. After all, if having struggling homeowners rent was a profitable alternative to foreclosure, then those banks and investors would already have put this plan into motion themselves. So unless taxpayers foot the bill for giving banks a carrot to participate, the administration must rely on coercion legislation.

Reuters confirms this possibility, referring to a version of the proposal suggested by economist Dean Baker some time ago:

Under Baker's plan, a bankruptcy judge would help determine a fair rent for the property. Banks would be able to sell the occupied homes, but the renter's lease would remain in effect.

This sounds very familiar, doesn't it? Why -- it's cram-downs version 2.0! Instead of rewriting the mortgage to a lower value thereby reducing the homeowner's payment, bankruptcy judges would be creating a rent for the house, out of thin air.

Most of the same pitfalls associated with the original cram-down plan still apply. Bankruptcy judges would still have an awful lot of power and would be forced to make decisions they aren't qualified to make. Banks and investors would also still have individuals in the house who they would probably prefer weren't -- because they are paying less than what their mortgage payment would have been.

The difference, of course, is that the mortgage would remain in-tact and whoever holds it could sell it to a new investor. I'm just a little unclear on what investor would want that mortgage: there are people who live in that house for judge-mandated amount of time, probably paying a rent below market value, because that's what a judge deemed they could afford.

While this plan doesn't tear up contracts with quite as much vigor as the original cram-down idea, it still forces banks and investors to be a party to a new rental contract -- whether they like it or not. As mentioned, they probably won't like it, or they would have already done this without the government forcing them to.

My final concern is that this could actually drive home values down further. If bankruptcy judges begin allowing people to rent at prices below where the market would put that rent, an investor will be willing to pay even less for that property than before. So while this might be a nice way to have homeowners avoid foreclosure, if the ultimate goal is to slow the decline of home prices, this plan could have the opposite effect.

Let me close with an amusing assertion by Baker, from the article, about why he believes his plan avoids moral hazard:

"Borrowers would lose their stake in the home so it is hard to say that they've gotten a windfall," he said.

That would be true if we were talking about homeowners who had built up a fair amount of equity. We aren't. This program would appeal almost exclusively to underwater homeowners. That means they don't have an equity stake in their home, because the value of their home is less than what they owe on their mortgage. While I wouldn't call that a windfall, I also wouldn't pretend like those borrowers are giving up anything to rent instead of foreclose.