Wednesday, October 12, 2011

Yes. Really.



Right out of college a few years back, my son was doing mortgage restructuring for M & I. He worked with a lot of debtors in Florida who would typically say that the bank should reduce the principal on their loan because their house was now worth half what they paid for it. Chris wondered whether they would agree that the bank could increase the principal if the house had appreciated in value.

It's easy to make fun of the young lady in the picture. Both she and her bank entered into a bad transaction. That she apparently does not understand that the bank is going to lose more than she will is probably a product of frustration rather than ignorance. She is stuck in a bad place and even though she put herself there, it is also a product of market developments that no one expected. It hurts and I can understand why she wants to blame someone else and get someone else to bail her out.

But to say that her plight is the simple product of someone else's greed and can be solved by making that someone else pay is incoherent. A commenter on this blog can't understand why it would be "destructive" to just forgive her debt and let her stay in her house. The comment is illustrative of the problem with many calls for state intervention to achieve "economic justice." It ignores the consequences of intervantion.

The problem with a broad standing debt forgiveness is that it would further seize - if it wouldn't destroy - credit markets. She might be happy until it came time to sell the home or to buy another and credit would be unavailable.

But what about the banks, weren't they bailed out? They sure were although much of that money was paid back. For me, the jury is still out on whether that was a good idea. The best thing would normally be to allow them to take their losses and move on. Maybe the threat of a panic in the fall of 2008 was such that there was no choice. Investors were shocked by the decision to let Lehman Brothers fail but that reaction was itself a product of a bubble and expectations that were themselves largely fed by government policy. Peter Wallison explains some of it (but not all of it) in today's Wall Street Journal.

Having said that, there are solutions for her. In all probablility, she won't have to pay anything in excess of the value of her house because, even in states where deficiency judgments are permitted, she can seek the protection of the bankruptcy courts.

H/T: Dan Sebring

22 comments:

gnarlytrombone said...

it is also a product of market developments that no one expected

He expected them. As did he. Not coincidentally, they both say the debt overhang is what's holding back the economy.

The problem with a broad standing debt forgiveness is that it would further seize - if it wouldn't destroy - credit markets

What'll destroy the credit markets is sudden deleveraging when most creditors stop pretending the phantom assets on their books - the loans made on property values inflated by too much loaning - are real.

Anonymous said...

The problem is that people want to refinance at the lower interest rates in order to prevent foreclosure but the banks are refusing to do it, which is compounding the problems for our economy.

John Foust said...

And those banks who received sorta-loans from the government to protect their "risks" without much question - they'll get their just desserts when forced into bankruptcy for their complicity, right?

And by "dessert" I mean champagne on the balcony of course.

Rick Esenberg said...

You don't work through "debt overhang" by indiscriminate forgiveness of debt - although a lot of it may be discharged in bankruptcy. I do think that banks have to clear their bad loans and I am pretty much opposed to bailouts so, yeah, I suspect that some may go in the tank. You aren't going to find much support for corporate welfare here.

Brew city brawler said...

So did you support TARP? if so, saying you're "pretty much" against bailouts doesnt seem to mean too much. And I dont recall many stirring denunciations of corporate welfare around here. Did Rite Hite (whose CEO seems challenged in understanding election laws) or any of your clients benefit from corporate welfare? Do any of the funders of the WPRI, for whom you write, benefit from/lobby for corporate welfare? If so, again, your lack of support for corporate welfare doesn't seem to mean too much.

gnarlytrombone said...

"debt overhang"

Ah, the infamous Shark Scarequote Sniff.

The debt overhang is the chunk of phantom wealth created by the aforementioned inflation of property values by the credit market, and the debt incurred on expectations of the continued expansion of that asset bubble. It's what Rick Perry might call the aftermath of a Ponzie scheme, and in this instance he'd be accurate.

You can wait for the real economy to actually produce that wealth and eventually make the creditors' paper assets actual. Problem is, as Japan has learned over the past 20 years, that takes an incredibly long time because the overhang also kills consumption and slows growth to a crawl. Meanwhile, you risk more rounds of financial panic and - like it or not - more corporate welfare to stabilize the system.

You can also choose to avoid those lost decades - as Sweden did in the early 90s - by proactively (and discriminately) managing deleveraging through mortgage cramdowns and other writedowns of excess debt.

Finally, you can inflate the excess debt away with Fed policy. Ken Rogoff, former chief economist at the IMF, suggests a target rate of 5 to 6 percent.

Tom said...

This reminds me of a commercial I keep hearing on the radio that says, and I am not exaggerating, that mortgages should be "illegal" because the bank is "stealing" your money every month.

I think a lot of this comes from the mistaken idea that your house should be an investment, and a good one. Even if your house does appreciate in value, the amount you've had to pay in "management" fees for your investment (taxes every year, insurance every year, interest for so long as you have a mortgage, repairs, upgrades) are several orders of magnitude higher than anything you'd pay on an actual investment.

People should get into the mindset that you are paying for a place to live and call your own, and you should pay whatever you are willing to pay for THAT value. Any decrease in resale value is immaterial unless you actually want to sell it.

Rick Esenberg said...

Whether or not banks are failing to properly mark assets to market is something that I don't pretend to know. It would certainly be illegal to fail to do so but they certainly could be overvalued.

But Mr. Trombone's observation has nothing to do with the protesters other than it would suggest that there be no more bailouts. I'd agree. So would the Tea Party and the GOP base. This is what bankruptcy laws. Given the extraordinary circumstances, it may be necessary, in addition, to set up a facility for disposing of toxic assets much as we did during the savings and loan crisis.

But debt forgiveness assumes that the values of the assets is zero - something which is certainly not true. It is, honestly, nutters.

George Mitchell said...

There is not much difference between Greece and many under water "homeowners." With the assistance of imprudent lenders, they find themselves without enough income to pay their obligations. In response there is a continuing search for painless ways to avoid the day of reckoning. Can't be done. Lenders and borrowers both need to take a hit. The consequence will be extended economic stagnation. The alternative? Print money and bail people out. That means devaluation/inflation of the euro and dollar and even worse consequences. If Obama is re-elected it means a plurality and perhaps a majority of voters are dumb enough to think there are easy answers.

gnarlytrombone said...

Hippie pinko protester Martin Feldstein jumps on board the debt forgiveness bandwagon.

Dad29 said...

as Japan has learned over the past 20 years, that takes an incredibly long time

Yah, but a look at Japan's demographics points to another big problem: too few chilluns (and ZERO immigrants).

That, too, depresses demand.

It's been argued that the Japanese problem is far more demograph-driven than debt-overhang-driven.

Same applies to Italy, Greece, and Spain, by the way.

Dad29 said...

It would certainly be illegal to fail to do so but they certainly could be overvalued

FASB allowed an exception for the banks about 2 years ago IIRC.

While the banks are in 'legal' compliance, there are valid questions as to whether the banks have "market" values on all their assets.

Anonymous said...

I'd be curious to know what percentage of those now underwater took cash-out refi's along the way.

Rick Esenberg said...

I don't think Feldstein's proposal - which leaves the homeowner underwater - is what Occupiers have in mind. In any event, it is an option that is readily available to any lender or borrower wishing to pursue it. I suspect that it doesn't happen for several reasons. First, it assumes that defaults are the product of people who could make their payments refusing to do so. I wonder if that's true particularly since many mortgage loans are with full recourse. Second, it assumes that current values will not rebound and that could be correct but lenders who refuse to offer such arrangements may believe otherwise. If they hold that belief, they are unlikely to agree to principal reductions. Third, the lenders get little in return since I suspect that recourse (if they don't already have it) is of little value with respect to most defaulting borrowers who would be effectively "judgment proof" for any deficiency. A more attractive - and perhaps fairer - option for lenders would be to convert some portion of principal in excess of value to a second mortgage payable only if a home's sales value exceeds the amount of the first and second mortgages by some specified amount.

One place where I might agree with you is that rigorous enforcement of "mark to market" requirements might force moments of truth that might result in mortgage modifications.

But I'm not sure that this would solve the problem. Apart from foreclosures, there seems to be way too much inventory and reducing someone's loan to 110% of its value still doesn't free them to move and I think that people being stuck in their houses is going to be a big problem. To the extent that permitting recourse is meaningful, it may make it worse.

gnarlytrombone said...

I don't think Feldstein's proposal - which leaves the homeowner underwater - is what Occupiers have in mind

You don't say. Does it qualify as "broad standing debt forgiveness" as a method of creating jobs? What happened to "You can't solve sluggish economic demand?"

Dad29 said...

Let's not forget that if you force banks to take haircuts, you're depleting bank capital dollar-for-dollar. That means that a bunch of banks will disappear.

And it's not my impression that the banks are reluctant to make 'deals'; rather, the regulatory thicket they must go through to get to 'the deal' is horrific--and then, there is the capital erosion above.

There IS too much inventory; it was seriously over-valued a long time ago by the rent/buy ratio and is still over-valued by that measure.

But that inventory was built with Greenspan foofoodust and bubbles, which goes back to his reaction to the Crash of '87(?) when the Dow dropped by 500 in one day. Greenspan arrived in Dallas, was greeted with the news, and triggered a massive cash-input. He followed with more cash (scrip, really) after the 'bust of the buck' with Primary Reserve.

That money had to go somewhere; after it came out of hi-tech and dotcoms, it accelerated the inflation of housing.

Rick Esenberg said...

I should point out that mark to market rules were revised in 2009 for inactive markets. Again, I don't know that banks are not complying.

George mitchell said...

Re feldstein, I like the idea of full recourse loans. I am far less enthused about my being partly on the hook for lenders and borrowers who made bad/greedy decisions. What other bailouts will responsible parties have to finance? To think it would stop with housing is to be in denial.

gnarlytrombone said...

Getting back to the point, which is Prof. Rick's febrile attempts at nutpicking the protests. I think Lloyd Hart is on the same continuum as a Martin Feldstein, just as a wild-eyed tea partier making unrealistic claims on budget balancing is in line with a Paul Ryan (although the latter may not be a sportsmanlike analogy on my part).

But if it's true that all's fair in love and politics, I pick Victoria Jackson as y'all's standard bearer.

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Dad29 said...

Just as followup:

During the financial crisis in 2008, the FASB issued a ruling that allowed banks to record a profit when the value of their debt collapsed. In other words banks report a profit when their credit-worthiness sinks.

In theory banks can buy back their debt at a profit. In practice, banks are so capital impaired they can't.


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