Would homebuyers be willing to share appreciation with their lenders?
Two professors suggest modifying standard terms of home mortgages to allow lower payments in a recession in exchange for upside appreciation. Would it work?
Are there any circumstances under which homebuyers would be willing to share in the upside on a home purchase? Last year I wrote about the concept of equity share as an option for housing bears. In that program, an investor puts up half the down payment in exchange for half the net profit at sale. Anyone who believes house prices will not rise would strongly consider such a deal because someone else ties up their money in the property rather than the buyer.
Today’s post concerns another idea two professors came up with to entice borrowers and lenders to share potential upside and downside in a real estate deal. They suggest that lenders would be willing to accept lower payment and interest on loans if prices went down as long as they were offered a share of the appreciation as prices went up. The idea is interesting, but significant issues arise when you consider how it would be implemented.
Bubbles, economist Charles Kindleberger once said, can’t exist without borrowing. His 1978 masterwork—Manias, Panics, and Crashes: A History of Financial Crises—dissected famous fiascoes. Looking at the Dutch tulip bubble of the 17th century, he showed that vendor financing pumped up tulip mania: The people who sold bulbs at inflated prices provided loans to the greater fools who bought them. We will never know what Kindleberger would have made of the 2000s housing bubble and the bust that briefly shaved $10 trillion off U.S. households’ net worth. But there is a hint in a Wall Street Journal profile published in 2002, the year before he died of a stroke at 92. “The object of his greatest fascination today is the real-estate market,” the Journal reported. “For weeks, Mr. Kindleberger has been cutting out newspaper clippings that hint at a bubble in the housing market, most notably on the West Coast.”
Kindleberger is identified as “a giant in economics” in a new book by Atif Mian and Amir Sufi called House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It From Happening Again. The lesson they draw from the long-time Massachusetts Institute of Technology economist is centuries old but almost deliberately forgotten. “Economic disasters are almost always preceded by a large increase in household debt.” To prevent the next disaster, they say, society should change the terms of debt contracts to make them more flexible and hence less harmful.
This is a classic example of defining the problem well but coming up with the completely wrong solution. Think about the problem more simply; if a large increase in household debt always precedes a disaster, wouldn’t the best solution be to prevent a large increase in household debt? Only a banker — or a clueless academic — would think the solution is to make the debt less harmful.
If you’ve heard of House of Debt, it’s probably because Mian and Sufi have emerged as the scourge of Timothy Geithner, the former Treasury secretary who admits to “empathy mistakes” in his own new book, Stress Test: Reflections on Financial Crises. On the Washington Post’s Wonkblog, they wrote that Geithner and the rest of the Obama administration should have pushed harder for writedowns of mortgage debt, and that their failure to do so “remains the biggest policy mistake of the Great Recession.”
Wrong! Well, partially wrong. We did need to purge a great deal more mortgage debt than we did, but widespread principal forgiveness, which is what they endorse, would have been the worst possible solution because it would create unprecedented moral hazard. Foreclosure is a superior form of principal reduction because both the borrower and the lender pay a price for their mutually foolish behavior.
On their own House of Debt blog, they wrote on May 19 that Geithner holds to the “thoroughly discredited” notion that saving the banks equals saving the economy. “That Geithner still adheres to this view despite all the evidence to the contrary is truly remarkable.”
On this I agree with them; Bankster bailouts did not save us from the second Great Depression.
Entertaining as it is, playing the financial crisis blame game gets us nowhere. A more useful contribution from Mian and Sufi is the shared-responsibility mortgage, their prescription to make economies less vulnerable to debt-fueled bubbles. In such a mortgage, lenders take some of the hit if housing prices fall and reap some of the reward if they rise. “Had such mortgages been in place when house prices collapsed, the Great Recession in the United States would not have been ‘Great’ at all,” they argue. “It would have been a garden variety downturn with many fewer jobs lost.”
How could they possible know how things might have turned out differently? There were any of a large number of changes to our system that would have stopped things from getting out of hand. Many of these changes were implemented in the Dodd-Frank financial reform. The best idea that didn’t make it into the reform package was to limit mortgage equity withdrawal, since the desire for mortgage equity withdrawal was the primary buyer motivation for participating in the housing bubble.
Their claim is bold, perhaps too bold, but the strategy for making debt less dangerous by putting a twist into the 30-year fixed-rate mortgage is sound. If an index of home prices in a home’s ZIP code fell, say, 30 percent, then the borrower’s monthly payment of principal and interest would also fall 30 percent. That’s not achieved by stretching out the length of the loan, which lenders sometimes will do: Despite the smaller payment, the mortgage would still get paid off over 30 years. Financially speaking, it would be equivalent to getting a reduction in principal.
These details are important: first, if prices fall, do owners get an automatic acceptance of a short sale with no recourse from the lender? That would help clear the market, but it would also hurt the banks. Second, does this apply to people regardless of the size of their mortgage? For example, if a borrower has 50% equity and really doesn’t need the reduction, do they still get it? Third, does exercising the contractual right to get out while prices are down cause credit issues for the borrower? If not, many more people would “bail and buy” to lock in a lower payment permanently rather than face the upward adjustment when prices rose again.
These ivory tower ideas are interesting, but the details of implementation matter, and if they aren’t carefully thought through, the program simply won’t work.
If prices recover, payments go back up, but never above the original amount. Lenders would ordinarily charge a higher rate for that protection, but Mian and Sufi calculate that they would be willing to forgo a bump on the rate if they were given some upside potential: 5 percent of any capital gain the homeowner gets upon selling or refinancing the house.
How did they calculate the 5% number? Much depends on the details.
Of course, now that lenders know the methods of loan modification can-kicking, the odds of a severe crash like 2008 are remote. Even if we had a flood of delinquencies, lenders would merely can-kick to prevent a market-crushing flood of foreclosures. Since it’s unlikely prices will ever fall that much again, lenders can get 5% of the appreciation upside with very little genuine risk, particularly if they only allow this on large down payment loans.
Lenders in every crisis hate to take losses, so they drag their heels on writing off bad loans. The overhang of unpayable debt depresses debtors’ spending, crushing economic growth. The beauty of a shared-responsibility mortgage is that it makes those painful but essential writedowns automatic.
And how would that work for the banks? The whole reason for suspending mark-to-market accounting was to prevent these write downs and maintain the illusion of solvency at the banks. I’m all in favor of the banks being required to write down their bad mortgages and hit the reset button, but obviously, our politicians are not. The “beauty” of this loan program is exactly why it has no chance of ever being implemented.
It would, the economists say, mostly end foreclosures, which devastate poor neighborhoods. Families lose their home when the price they can get for it is lower than what it would cost to pay off the mortgage.
Lenders already learned how to end foreclosures with loan modification can-kicking. Why do they need to modify the standard terms of the contract?
With a shared-responsibility mortgage, when the value of the house goes down, so does the cost of paying off the mortgage. The reason: The loan’s worth becomes less to the lender. Imagine that a home’s price goes down 30 percent and the payment automatically goes down by the same amount. Then a banker who was owed $100,000 will (with gritted teeth) accept $70,000 for a loan payoff. That’s all the stream of income is worth at the new, reduced level of monthly payments. (Well, more or less, depending on whether lenders and buyers perceive values the same way.) Reducing foreclosures this way benefits the whole neighborhood, because foreclosed houses bring down surrounding property values.
This is a completely unrealistic idea, and it will never happen.
Strong arguments can be made for a ten to twenty year bear market in real estate. We are at the bottom of the interest rate cycle, and for the next thirty years, we may face an environment of slowly but steadily increasing interest rates similar to what we saw between 1950 and 1980. If that comes to pass, borrowing power will be steadily eroded just as it was steadily increased over the last 30 years. Combine this with the likelihood of a decade or more of underemployment and stagnant wages, and you have a recipe for house prices to go nowhere for a very long time. Under those circumstances, perhaps some downside insurance purchased at the expense of potential upside is not a bad idea. It’s too bad, it will never happen.