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A Cure for the Housing Blues

The cramdown solution.

Nov 7, 2011, Vol. 17, No. 08 • By IKE BRANNON
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The biggest impediment to economic growth is the housing overhang, a fact that’s beginning to be acknowledged by both parties. In the last three weeks Glenn Hubbard and Martin Feldstein​—​two former Council of Economic Advisers chairmen for Republican presidents​—​published op-eds with plans for writing off some portion of the mortgage debt for homeowners whose mortgage exceeds the value of the house, a status typically referred to as being “under water.” Meanwhile, the Obama administration last week chimed in with its latest plan to spur refinancing by homeowners whose under-water loans are held by Fannie Mae and Freddie Mac, hoping that lower interest rates will keep these borrowers from defaulting.

Photo of a foreclosed house

Nearly 25 percent of homeowners hold mortgages for more than their houses are worth.

Mark Avery / Reuters / Landov

The weight of the collapsed housing sector on the economy means that no amount of stimulus, whether a short-term Keynesian fix or a conventional pro-growth package, will fix this problem. Not only are nearly 25 percent of homeowners holding mortgages for more than their houses are worth, there are also nearly four million households that have stopped making mortgage payments at all. In the time it takes​—​usually one to two years, sometimes longer​—​for the legal system to put them into foreclosure and make them move out, these families (and the mortgage holders) find themselves in an uneasy limbo: The mortgage holders aren’t getting any money and the families aren’t spending all that much either, with the result being that consumption, lending, and the overall economy stagnate.

We don’t need another stimulus to fix what ails the economy. We need to fix the housing market. And the way to do that is to allow a mortgage cramdown in the context of a personal bankruptcy. Put simply, someone who owes $450,000 on a house worth $300,000 isn’t going to be helped that much by a lower interest rate. He would be helped​—​as would the housing market and the larger economy​—​if the lender could be compelled in a bankruptcy proceeding to write down the loan amount to $300,000, which is all the lender would recover in any case were it to foreclose on and then auction off the property.

Bankruptcy Made Simple

A person who files for bankruptcy can choose to do either a standard or so-called Chapter 7 bankruptcy (named for that portion of the bankruptcy code), or he can file for bankruptcy reorganization, also known as a Chapter 13 bankruptcy. Under the latter plan the debtor and his lawyer present a list of his assets and debts to the judge and bankruptcy trustee, acting on behalf of the creditors, and they negotiate a repayment plan. Such plans usually cover three to five years, with the trustee receiving periodic payments from the debtor and doling them out to his various creditors.

Completing a Chapter 13 bankruptcy plan discharges most debts even if they are not paid in full, save for taxes, student loan debt, and a few other exceptions. Among the most important exceptions are home mortgages. A bankruptcy judge is not allowed to reduce the value of a home mortgage. 

In this, a primary mortgage is unique among debt that is secured by some sort of collateral. If the debtor has a car, a boat, or a second home for which he owes more than the current market value of the asset, the judge can reduce the amount of the debt to the market value. It is in both sides’ interest for the judge to have this power: Otherwise, debtors who file for bankruptcy would simply relinquish title to the property, and the creditor would then have to go and find a buyer, at some cost to him. Writing down the value of the debt gets the creditor the same amount of money as if he had taken possession himself and sold it, but without the hassle.

Allowing such a cramdown for a mortgage on a primary residence would require us to acknowledge a simple fact: The person who owes $450,000 on a house that is currently worth $300,000 is almost assuredly never going to pay the full amount he owes; eventually, he will either be granted a loan modification to reduce the principal or else he will walk away​—​no matter how much we try to shame him into “doing the right thing.” The cost of walking away in most states amounts to little more than the inability to buy another house in the next five years, since most mortgages are in practice nonrecourse loans, meaning that the debtor does not have to make up any deficiency if he returns the house to the mortgage holder and it sells for less than the mortgage. 

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