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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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At the moment, mortgage loan modifications are entirely at the discretion of the lender. But thanks to the disintermediation of the mortgage market in recent decades, negotiations between the mortgage holder and the debtor can be nearly impossible to initiate, despite a plethora of administration programs designed to ameliorate this problem. (The mortgage holder is typically an investment bank or some other investor who holds it along with a host of other mortgages in a mortgage-backed security.)

Ironically, one of the arguments offered for exempting home mortgage loans from being crammed down in the 1978 bankruptcy reform was that the community banks and savings and loans that issued most home loans were well-positioned​—​and had an incentive​—​to negotiate with a financially troubled homeowner to avoid foreclosure. As that is no longer the case, bankruptcy judges should be given the power to impose cramdowns.


Republicans typically react to suggestions of mortgage cramdowns with indignation, arguing that it sets a bad precedent and rewards speculators and people who didn’t play by the rules. There is some truth to this: For instance, economists Michael LaCour-Little, Vincent Yao, and Eric Rosenblatt find that a good portion of foreclosed homeowners in Southern California bought their homes well before the peak of the price bubble and managed to extract a considerable amount of equity from the home before the crash. They estimate that the typical return on equity for those with foreclosed houses approaches 40 percent​—​not a bad haul.

However, should meting out fiscal justice trump economic expediency? It’s a question that policy-makers have asked themselves previously. In his book The Banking Panics of the Great Depression, Elmus Wicker notes that the Federal Reserve maintained a tight monetary policy well into the 1930s that they knew would lead to the collapse of banks throughout the country, which in turn would crater the economy. Nevertheless, they held fast to this path not just because of a Darwinian economic perspective but also because of a widely held notion (at least within the Fed) that helping these troubled banks would be rewarding failure.

Phillip Swagel, assistant secretary for policy at Treasury in the latter years of the Bush administration, wrote in a paper for the Brookings Institution that his old bosses rejected any cramdown because they feared its subsequent impact on the lending markets for middle-income households. Resorting to a cramdown, they reasoned, would lead mortgage issuers to tighten credit standards as well as demand higher down-payments. It’s safe to say that this ship has sailed. Cramdown or no cramdown, credit standards are tightening and higher down-payments will be the rule.

Who Gets a Break?

Ultimately, America has a choice: Do we continue to insist that the people who made bad bets in the housing market get punished for their wagers, or do we focus on creating policies that have the best chance of ending our economic malaise? Once we decide that the latter should take precedence, the next step is easy: We allow mortgage cramdowns to occur in the context of a Chapter 13 bankruptcy reorganization.

By doing it in the context of bankruptcy, we set a high bar on who takes advantage of a cramdown: Someone who is marginally under water is not going to want to go through the proctology exam that comes with a Chapter 13 bankruptcy or to pay the thousands of dollars of lawyers’ fees to file. But someone $100,000 in the hole is likely to explore the possibility​—​exactly the incentive we want to create.

The worry that mortgage-holders are going to take a hit is valid: While granting mortgage relief through bankruptcy minimizes the costs of fixing the housing market, the government may still find it necessary to provide some sort of relief to various holders of mortgage-backed securities, which would be politically unpalatable but much less expensive than the president’s proposed $447 billion stimulus plan, while having the advantage of actually providing real stimulus.

But the true cost of a cramdown will not be that significant: At the end of the day the investors holding mortgages aren’t likely to get more for their mortgages than what the houses are currently worth. So the real question is who should live in those houses? The people now in them, or the people who would buy them for pennies on the dollar after the wrenching and complicated ordeal of a foreclosure and auction?

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