With house prices still falling, it's natural that we're still talking about a program to do principal write-downs on home loans.  Tyler Cowen makes probably the best case for it:

I know that a) this idea is WRONG, b) it is terrible for the long run rule of law, and c) it is EVIL and UNFAIR. It's also one of the few suggested economic remedies that might have worked or maybe could still work.

How so? It limits value-destroying foreclosures. It gives homeowners the right marginal incentive to keep on making payments and maintain the value of the home and to maintain their credit capabilities. It gives the housing market a fresh start rather than this waiting/coordination game where we wait for everyone to move on down a notch in house quality, thereby freezing parts of the housing market and choking off required recalculations. (How can you have a well-functioning housing market when so many people have negative equity? I've read estimates of twenty percent of the U.S. population.) It also limits the problem of future ARM resets, once interest rates rise in the future.

It's all about long-run vs. short-run and I usually side with the long run. But the short run modification of property rights has so many defenders in other contexts, so why not here? Call it "clearing up financial logjams" if you wish.

Is it a better marginal incentive than suddenly increasing the taxes on banks?

Bernanke himself once suggested the idea.

I might add that by fostering an actual recovery, writing off the principal on mortgage loans might limit some of the other bad interventions that we will try or have ended up trying.

I don't think it's particularly evil.  But I'm also not sure that it's a good idea.

Let's think about why principal write-downs work, at least in theory.  As I see it, there are three reasons:

  • It increases the willingness of homeowners to work hard and sacrifice to keep their house current
  • It lowers the mortgage payment
  • It allows people to sell rather than go through foreclosure if they have an income shock, or need to move
Together, these substantially reduce the likelihood of foreclosure, which theoretically makes both consumers and banks better off.  However, there are some reasons to worry that this wouldn't make a huge difference right now:

  • We don't have the mortgage problem that we initially thought.  We expected that foreclosures would be driven by resetting adjustable rate mortgages, i.e. higher payments.  But with interest rates so low, the problems are on the income side.  Either people took on more mortgage than they could afford, or their income has fallen, so they can't afford the mortgage they have.  This is why most modifications are failing.
  • That means that people don't necessarily have the resources to pay even a reduced mortgage.  Say you had a house that was worth $280,000 with a $250,000 mortgage, but whose value has now fallen to about $200,000.  We write down your mortgage principal to the home's new value, handing the bank a 20% loss.  What is your new payment?  Assuming the interest rate stays the same (or were we also going to force them to take an additional interest rate loss?), it's probably fallen by about $300.  For the typical person with a $1400 house payment, $300 a month is not the difference between solvency and bankruptcy.
  • They won't be able to refinance, either Bank's aren't doing refis at 100% LTV with property values still falling, unless they own the mortgage and think you're about to default.
  • It does allow them to sell--if they can  There's not a huge amount of demand out there. It doesn't help the economy if we switch from foreclosure sales to underwater owners dumping the houses on the market.  It does reduce the legal transaction costs--maybe.
As far as I can tell, the only problem this really fixes is that people are more willing to pay when they're not underwater.  But is the notion that housing is a gamble, and mortgages are some sort of a call option on the future value of the home, actually something we want our legal system to encourage?  This starts looking less like a macroeconomic fix, and more like a way to transfer substantial money from banks to homeowners because we like homeowners better.  

In doing so, we'll further impair the balance sheets of anyone who put capital into the real estate sector, and also create political outrage from the legions of homebuyers who didn't overstretch themselves on real estate.  This has both economic and civic costs.

Moreover, I think that at least in the American legal system, a principal write-down program is going to be way more complicated than anyone thinks.  I can see three ways to do it:

  • Pass a law forcing banks or servicers to write down the principal on underwater loans
  • Pass a law paying banks or servivers to do same
  • Allow cram-downs in bankruptcy.
My sense from reading, and talking to people in the administration, is that they gave up on the first because it was insanely more complicated than people thought, was going to trigger years of legal challenges, and was obviously going to drop a nuclear bomb on mortgage investments that were already in big trouble; if you forced them to write down the principal on any underwater loan, then to a first approximation, every single underwater homeowner was going to apply for a modification.  The next step would be bank failures, contracting credit, and further downward pressure on the housing market as loan volume dried up, and modified homeowners tried to sell.  That, of course, would push more homeowners underwater.

Which brings us to the second problem with option one: how do you value the houses?  Writing down the principal on things like auto loans takes place in a very liquid market where prices are well established, and cover only a few thousand models of cars.  Housing is not liquid at the best of times, each house is a highly specialized product, and with prices falling, historical comps no longer act as a safe floor.

The problem with paying banks is that all the losses you've forced onto the banks, instead end up on the government, with the added wrinkle that no one has much of an incentive to fight ludicrously low appraisals.  This was never politically feasible--reward profligate homeowners without punishing banks?  Ha!  But it's not even on the horizon in an era of deficit panic.

That brings us to the third option, by far the most realistic.  But it's far from the panacea that some people seem to think.  It's not clear to me that all the pundits in favor of this solution understand that mortgage cramdowns only happen in Chapter 13 bankruptcies, not Chapter 7.  Homeowners are not going to be able to walk into court and have the excess balance on their mortgage cleared, then walk away.  You can reaffirm debts in Chapter 7 (and my understanding is that prior to this crisis, that's what most people did with their mortgage).  But you have to pay the whole payment. The only way to get a write-down of the principal balance is to enter a Chapter 13 payment plan, which lasts years and as I understand it, usually requires that creditors get at least as much as they would have out of a liquidation.  In other words, while bankruptcy judges are generally pro-debtor, they are not in the business of allowing people to stiff their creditors without penalty to themselves.  if you have enough (non-exempt) assets or income to pay off the underwater balance, the judge is not going to help you reallocate that money towards other consumption.  Chapter 13 plans are far from draconian, but they are generally set at levels that require considerable spending discipline.

Chapter 13 plans have fairly high administrative costs, requiring court oversight of debtor and creditor relations for the term of the payment plan; that means that the administrative savings on avoiding foreclosure will be considerably attenuated.  They also fail more often than not; either the debtor reconsiders and converts to Chapter 7, the filing is dismissed, or the debtor can't keep to the plan.  When these plans fail, debtors with "crammed down" loans are often worse off than if they had never filed, because if you don't complete the plan, you owe the banks all the money you haven't paid them, plus interest and possibly penalties.

Moreover, a Chapter 13 cram-down law would not have the sort of sweeping benefits that some of its proponents envision.  Somewhere north of 10 million homes in America are underwater right now.  At their very peak, the courts handled slightly over 2 million filings in one year (2005), but that was an anomaly driven by the 2005 reform bill; a more normal load is about what they handle now, 1.5 million.  Even if the courts worked flat out, it would take years to process even a fraction of the underwater homes through Chapter 13.

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That's not necessarily an argument that we shouldn't allow cram-down in bankruptcy--though as with the 2005 reform, I'm deeply uncomfortable with rewriting the rules covering loans that have already been issued, so I'd rather see us change the rules for newly issued mortgages.  It's essentially a social choice: do we want to make loans cheaper for the majority of people who don't declare bankruptcy, or do we want to make things easier for the minority of people who do?  I'm generally pro-easier-bankruptcy, but I'm also aware that more expensive mortgages would further damage an already hurting real estate market.

Which brings us back to the immediate topic at hand; how much would this help the economy?  As we've seen, I'm skeptical that it would do as much as its proponents claim to relieve the financial distress of hurting families.  If the write-downs are accomplished through bankruptcy, as I expect they would be, we would save less than promised on the legal and administrative costs.  And the theoretical economic benefits--increasing labor mobility, easing the downward pressure on the housing market--would be at least partially mitigated by reduced loan availability for new purchases, selling pressure from those whose mortgages have been written down, and general lack of housing demand.  Plus the haphazard nature of the housing valuation process would create windfalls and tragedies that would continue to be politically corrosive.

It's easy to see the appeal of cram-downs--they seem like a relatively simple solution that instantly sweeps away a lot of the problems we've had.  But when you start considering the actual problems of execution, they start looking--to me, at least--considerably less appealing.  I'm not saying we shouldn't do them--as I say, I can see the arguments on both sides.  But even if we did go this route, the benefits would be at best small and mixed.