America needs a way to stem foreclosures

October 9th, 2012

February 24, 2008

The American economic outlook remains highly uncertain. But macro­economic policy is now properly aligned, as the economy will benefit over the next several quarters from fiscal and monetary stimulus. To the extent conditions warrant and inflation risks permit, monetary and fiscal policy are appropriately poised to provide further stimulus.

Policy towards America’s failing housing sector is in a far less satisfactory state. All honest analysts accept that policies adopted so far, such as the “teaser freezer” limits on resetting mortgage interest rates and increased federal support for mortgage lending, have had only a marginal impact on what may be the most serious crisis in housing finance since the Depression.

It appears house prices are down by 5-10 per cent from their peak, with derivatives markets predicting further declines of about 20 per cent. Price falls of this magnitude are likely to mean more than 10m would have negative equity in their homes and more than 2m foreclosures would take place over the next two years.

Foreclosures are extremely costly. Between transaction costs that typically run at one-third or more of a home’s value and the adverse impact on neighbouring properties, foreclosures can easily dissipate more than the total value of the home being repossessed. They also inflict collateral economic damage, as reduced wealth and diminished borrowing capacity in homes reduces consumer spending, increases credit market fragility and depresses local tax bases.

What can public policy do? It cannot and should not try to fix the fact that at current prices the supply of homes significantly exceeds demand or the reality that many own homes, often for speculation, that are no longer viable and should be back on the market.

But it can and should address a crucial issue: when the current owner is able and willing to pay more than the lender can get by foreclosing on a house, it makes no sense to go through with a foreclosure. Yet because of conflicts among lenders, legal uncertainties and concerns about encouraging defaults, there are grounds for fearing that wasteful and unnecessary foreclosures will take place on a large scale, hurting families, communities, the economy and the financial system.

How can this problem be addressed? The string has pretty much been played out on hortatory policy, to limited effect. Without finding ways of writing down mortgage liabilities, new finance will do nothing for the problem group that has negative equity. Direct government intervention in mortgage markets risks creating delays, burdening taxpayers and inhibiting necessary adjustments in house prices.

The right focus is on measures that will prevent unnecessary foreclosures by facilitating more efficient settlements between homeowners and their creditors. Legal changes currently being debated, to bring practice with respect to family homes into conformity with general bankruptcy practice in two areas, could make an important contribution.

First, remarkably, bankruptcy laws currently provide that almost every form of property (including business property, vacation homes and those owned for rental) except an individual’s principal residence cannot be repossessed if an individual has a suitable court-approved bankruptcy plan. The rationale is the prevention of costly and inefficient liquidations. It is hard to see why similar protections should not be prudently extended to family homes.

Critics worry that such measures will dry up the supply of mortgage credit. This is a legitimate concern and the reason why legislation should be carefully and narrowly drafted, to be applicable only to past mortgages where there has been no fraud and where foreclosure is otherwise imminent. But it is worth noting that: some inhibition on lending to those who seem likely to go bankrupt might be a good thing; also, there has been an adequate supply of capital and ability to securitise in the market for vacation and rental housing, where debtors are protected; and moreover, chapter 12 of the bankruptcy code enacted in the mid-1980s, which applied these principles to family farms, helped to resolve great financial distress without long-term costs in terms of reduced farm lending – despite protestations much like those that are heard today.

Second, methods need to be found to enable creditors who accept a writedown in the value of their claims to retain an interest in the future appreciation of the homes on which they have mortgages. This is standard practice in situations of corporate distress, where debt claims are partially replaced by equity claims.

Obstacles to such mortgages include uncertainties about tax and accounting rules. But at a time when there are great advantages to inducing lenders to let families to remain in their homes – and when families facing foreclosure are prepared to do things they might not do in ordinary times – it would be desirable to pursue suggestions by the Office of Thrift Supervision for so-called negative equity certificates to support shared appreciation work-outs.

Bankruptcy reform alone could, on some estimates, avert 500,000 foreclosures and, by establishing templates for renegotiation, aid a wider restructuring of mortgage debts. Proper support for voluntary restructurings involving interests in future appreciation should realise still greater benefits. As with fiscal stimulus, rapid bipartisan co-operation between Congress and the administration would benefit the financial system, the real economy and millions of Americans.

The writer is Charles W. Eliot university professor at Harvard

Copyright The Financial Times Limited 2012.