Writing down the principal on mortgages

by on January 18, 2010 at 8:35 am in Economics | Permalink

It's obvious that the economy still isn't doing well.  Furthermore the rate of foreclosures won't peak until the end of 2010.  On top of that, most observers agree that the Obama mortgage modification plan has been a failure.

That all said, I'm surprised that so few commentators have leapt on the "we should write off some of the principal" bandwagon.  It's not currently a bandwagon at all.

I know that a) this idea is WRONG, b) it is terrible for the long run rule of law, and c) it is EVIL and UNFAIR.  It's also one of the few suggested economic remedies that might have worked or maybe could still work. 

How so?  It limits value-destroying foreclosures.  It gives homeowners the right marginal incentive to keep on making payments and maintain the value of the home and to maintain their credit capabilities.  It gives the housing market a fresh start rather than this waiting/coordination game where we wait for everyone to move on down a notch in house quality, thereby freezing parts of the housing market and choking off required recalculations.  (How can you have a well-functioning housing market when so many people have negative equity?  I've read estimates of twenty percent of the U.S. population.)  It also limits the problem of future ARM resets, once interest rates rise in the future.

It's all about long-run vs. short-run and I usually side with the long run.  But the short run modification of property rights has so many defenders in other contexts, so why not here?  Call it "clearing up financial logjams" if you wish.

Is it a better marginal incentive than suddenly increasing the taxes on banks?

Bernanke himself once suggested the idea.

I might add that by fostering an actual recovery, writing off the principal on mortgage loans might limit some of the other bad interventions that we will try or have ended up trying.  There's more than one way to toss away the rule of law.

1 JohnBailey January 18, 2010 at 8:48 am

While the mortgage balance vis a vis the property value is important, even more important is whether the home owner has actual value in the property. It is also important that we have property values that reasonably reflect long-term market conditions.

My suggestion is to allow a home owner to, in effect, buy his own house in a `short sale.` under the condition that the he/she/they are able to get a mortgage lender to finance the sale and the home owner has a substantial interest (20%).

Other buyers, including the current mortgage holder(s), would have the option of buying the house at that or a higher price. That option would help to insure that home owners offered the highest price that they could afford.

Assuming that someone was able to purchase the house, the current homeowners would be out without having their credit scores impacted.

What is unclear is who would bear the loss.

2 Nemo January 18, 2010 at 9:33 am

“EVIL and UNFAIR” does not even start to cover it.

You want to hand billions of dollars to the people who gambled and lost, on the backs of those who saved responsibly?

Well, f*** you. I would rather live through a depression.

What is the lesson supposed to be? That the next time everyone around me is walking off a cliff, I should go with them, because I am going to pay all of the costs anyway?

More personally, I want to buy a house someday… But I refuse to do so while they remain massively overpriced, propped up by idiotic tax credits and manipulated interest rates.

So, more foreclosures, please. Thank you!

P.S. Please stop conflating the “value” of a house with its price.

3 George Wendt January 18, 2010 at 9:47 am

I think it is perfectly fine for the banks to write down some mortgages on their own accord but the government should not have any place in this decision process. The government’s job should be to help enforce contracts through courts or law, not to disrupt contracts which were validly and legally entered in to.

The argument that we should do this to avoid other bad interventions also poses some problems for me. Perhaps we just shouldn’t do any silly interventions that just serve to incentivize negative behavior. I understand that this gets politically difficult but elections come and go and the negative incentives always remain and as you said yourself I prefer the long run benefits over short run benefits.

I really like this blog and just disagree with this particular post. Have a great day.

4 Sonic Charmer January 18, 2010 at 10:02 am

Who’s the “we” that is supposed to write down that principal?

Our laws already provide for enforced writing down principal on loans, it is a tried-and-true predefined process called ‘bankruptcy’. If the issue is that there are just too many people who would need to ‘move a notch down in housing’ for this method to run its course without ‘clogging’ everything, well, I claim that if the government credibly committed to sticking with the rule of law without constantly coming up with ‘clever’ interventions and ‘programs’, then most mortgage holders – faced with the prospect of having to go through the BK/foreclosure/REO process on a huge % of their portfolio – would write down the principal themselves, on their own volition, by setting up a principal-forgiveness program. Without any intervention or prompting from the government, or “we”, whatsoever.

Indeed, I have seen it happen.

Seems to me the way to get where you want is to stick with the rule of law, not to be constantly thinking of ‘clever’ solutions outside of it.

5 Thomas January 18, 2010 at 10:24 am

Why don’t we try Scott’s idea instead?

6 Douglas Knight January 18, 2010 at 10:30 am

Since the US has non-recourse mortgages, this would happen on its own, except that banks have an incentive to bury their heads in the sand. That is the incentive that needs to be fixed, regardless.

7 David January 18, 2010 at 10:33 am

I can think of lots of WRONG, EVIL, UNFAIR things that could help us out “economically.” Should we make a list?

8 Anastasia January 18, 2010 at 10:35 am

I am not sure how “evil” or “unfair” this actually would be. The alternative would be to let a bank foreclose, then taking a loss on the value of the original mortgage and/or allowing the property to sit and lose value in an oversatiated market. Writing down the principal on the existing mortgage seems as though it would remove a few steps from this process while allowing a homeowner to at least retain their home, and the bank still takes a loss. I suppose the evil and unfair part would be existing, not under-water homeowners not being “rewarded” for actually affording their homes, but in effect this kind of policy would in the long-run stabalize the values of all homes (under water and above), right? I think this may provoke a similar kind of anger amongst the populus as the other “bailouts”. On the other hand, the idea of “right to rent” similarly keeps people in their homes, those homes out of the market, and could have a long run stabalizing effect, by negotiating long-term leases (1-10 years) on homes with lenders, enough time for a “recovery”. As a student, I’m not expert on these things, so I would be interested in reading more critiques on these alternatives.

9 Pedro January 18, 2010 at 10:50 am

Lew Ranieri, who you may remember from the book Liar’s Poker and who knows more about mortgage finance than most people will ever know about anything, has been pitching packaged principal writedowns refinanced into new shared appreciation loans for at least a couple of years now. Every bank that meets with him agrees that it makes sense financially for them to do it, even with no government incentives. And yet, only Wells Fargo is actually making it happen; nobody else seems to be willing or able to put the systems in place to do it. It’s simply a failure of management in the mortgage arms of banks.

10 Andrew January 18, 2010 at 11:03 am

It’s hard to even talk sense to people. There is no virtue in the pain if it doesn’t cause understanding.

We are in the regime of indiscriminate punishment. EVERYONE has already been punished and the point is that the punishment has lost its sting which is why people are walking away from their homes. You can’t foreclose on everyone.

So, how can you avoid doing that in a just way? You let the people involved in the contract renegotiate. How do you do that so that banks take the initiative? Well, you have the government craft the accounting rules they already use to threaten banks (in a pro-cyclical manner by the way) to facilitate the renegotiations in a way that doesn’t extract value from others in an unfair way. One way is to reduce payments by extending the duration of the loan.

11 Noah Yetter January 18, 2010 at 11:17 am

I agree that’s the right thing to do. But if the feds came a-knockin’ and offered you a free principal write-down, would you turn them away? Would it be right to condemn you for accepting that offer?

12 Andrew January 18, 2010 at 11:29 am

Oh, btw, shouldn’t you be mad at the people who sold the houses? Shouldn’t you be mad at the people who are walking away from their mortgages? Aren’t these the people causing the crisis?

It’s not like the banks and others are getting away unscathed. But by not putting something in place it is the actual evildoers that are getting away scot free.

Why cut our noses off to spite our face?

And yes, it’s a market failure, but in the most heavily regulated, subsidized, intervened, and populist area of finance, so let’s not go THERE, shall we.

13 PQuincy January 18, 2010 at 11:40 am

I’ve been bemused by the lack of mortgage-holder action on this front. One might expect that banks had a major incentive to restructure mortgages, even at a loss, to ensure a steady cash stream from committed owners. Instead, for pretty visible institutional reasons, even when some or all of the mortgage holders may recognize this incentive, a combination of holdout minority stakeholders (e.g. second mortgage holders), absent or distant mortgage owners (securitized mortgages in sliced-and-diced pools) and regulatory perverse incentives (reasonable or not) such as the ability to hide losses by pretending they haven’t happened, keep the restructurings from being possible.

What I don’t understand is the vindictiveness of some writters (e.g. Jolly, above) who think that home purchasers were the only miscreants here. Tell me, is a bank that loaned a large amount with no down payment and no documentation to a relatively poor person completely innocent of misbehavior? Of course there were speculators who gamed the system — but my impression is that if we look at cui bono, the big gainers were not home buyers, but rather mortgage brokers, investment banks, etc. Why the anger at those who have NOT benefited, but silence on those who did?

Moreover, in most states, mortgages are non-recourse. Bankruptcy is not required for a foreclosure or an abandonment of a property — indeed, thanks to Congress, a bankruptcy cannot discharge a mortgage. Banks surely see that many economically rational buyers have every incentive to walk away from their mortgages. They are doing nothing illegal, and nothing different from many major corporations that are walking away from their commercial mortgages. Of course, such actions have consequences, but they are in conformity with the terms of the mortgage.

Again, why such anger at people who are behaving rationally — and this at a libertarian rational-choice-oriented blog?

14 Bob Murphy January 18, 2010 at 11:48 am

Tyler wrote:

Is it [writing down the principal] a better marginal incentive than suddenly increasing the taxes on banks?

Perhaps so, but the only reason suddenly increasing the taxes on banks is politically possible, is because of the TARP program which you supported as a way to limit government intervention.

15 mulp January 18, 2010 at 12:38 pm

why else has Congress spent a ridiculous amount of time and effort to subsidize home ownership for decades??

Because conservatives keep saying that property ownership solves every single problem of poverty.

“If Haitians owned the land, they wouldn’t deforest Haiti….”

“If the poor owned their homes, there would be no slums….”

“If the squatters owned their shacks, they could borrow against their shack to get money for a business…”

“The reason the economy in the US is growing so much faster than in China is US property ownership rights which don’t exist in China….”

And most important, the “pursuit of happiness” was defined by government confiscating land of non-white people and giving it to white people. What year did Congress pass the Indian Removal Act?

16 Sonic Charmer January 18, 2010 at 12:59 pm

But if the feds came a-knockin’ and offered you a free principal write-down, would you turn them away? Would it be right to condemn you for accepting that offer?

No, it would be right for the feds to give that offer.

Again: who are the feds to “write down” the principal of a loan owed by X to Y? There is one legal process by which this can be done, and it is called bankruptcy.

17 Sonic Charmer January 18, 2010 at 1:03 pm

Tell me, is a bank that loaned a large amount with no down payment and no documentation to a relatively poor person completely innocent of misbehavior?

Not sure I get this critique. Another way to say this is that the bank bought a nice big house for a relatively poor person who couldn’t really afford it.

EVIL, EVIL BANK!

By this standard, to not be a “miscreant”, banks should be tightwads with their money, and have really high standards, etc, etc. But when they do that,

EVIL, EVIL BANK!

18 Sisyphus January 18, 2010 at 1:13 pm

I am surprised that more banks aren’t offering 40 year or 50 year mortgages (whether fixed rate or not) to their existing mortgage-holders as a way to reduce their foreclosure rate on their portfolio. It seems like a relatively straightforward trade where both sides have some gains – more interest upfront for banks and lower monthly payments for the homeowners (which is the main thing most homeowners care about). Of course, the longer time horizon creates higher risks, but that is probably an acceptable trade for both parties if the alternative is the home goes into foreclosure. Unless there are laws prohibiting mortgages of this length (which should be changed), there’s no reason this couldn’t be voluntary. I believe Japan already has significant experience with 40 and 50 year mortgages, so they aren’t particularly novel.

Of course, this does not address the problem of people who can’t really pay any mortgage because they are unemployed, underemployed, etc. Loan modifications or refis aren’t going to help them. But it would help those who overextended but otherwise could pay in their purchases.

19 mulp January 18, 2010 at 1:29 pm

sonic charmer: “Not sure I get this critique. Another way to say this is that the bank bought a nice big house for a relatively poor person who couldn’t really afford it.”

If only that were the reality.

The reality is the bank took Sonic charmer’s money market funds and bought a poor person a house with the bank speculating that the house would increase in value enough for the bank to roll over the mortgage and repay sonic charmer before sonic charmer tried to draw out his money. How is the bank any different than Bernie Madoff? The bank represented the bonds as worth something, just as Madoff gave his investors statements that represented investments worth something.

It was only the Fed and FDIC extending retroactive deposit insurance to trillions in money market funds plus the tax payers paying billions by way of AIG to the banks so the banks could unwind the short term debt provided by sonic charmer used to finance a big part of the subprime mortgage ponzi scheme.

20 Honest Person January 18, 2010 at 1:57 pm

I am puzzled to see the vitriol in response to Tyler’s good question. Having the government come in and modify the private contracts and reduce the principle would be socialism for the irresponsible middle class. There is obviously no big aversion to socialism in this country, but what the media and politicians promote is socialism for Goldman Sachs, JP Morgans, Warren Buffets and David Rockefellers of the world. That means “pay in full bitches”. Your gonna have to pay more taxes too…ALL OF YOU LITTLE PEOPLE. The people hoping for lower house prices should have to pay double for not falling in line with the oligarchs game to start with.

21 John Dewey January 18, 2010 at 2:14 pm

Honest Person,

I’m not sure I understood the comment you just posted. Just so we’re clear, most true conservatives are just as opposed to socialism for the Goldman Sachs and David Rockefellers as they are opposed to “socialism for the irresponsible middle class”.

22 David January 18, 2010 at 2:20 pm

Boonton, why would the banks relinqusih first lien voluntarily?

23 Sanjiv Das January 18, 2010 at 2:29 pm

Hi — I have written a paper providing a full-blown analysis of this point. It shows how to compute optimal principal write-downs in the presence of value-destroying foreclosures. The URL is

http://algo.scu.edu/~sanjivdas/loanmod.pdf

cheers

24 anonymous January 18, 2010 at 2:39 pm

One way or another, there will be a principal reduction program of sorts. It will probably be called “inflation”.

25 Honest Person January 18, 2010 at 2:56 pm

John Dewey,

Whatever label you put on it”true conservative” or not…the democrat and republican politicians in place have put forth socialism for the powerful. I know that many libertarians were clearly and consistently against the socialism for the powerful a.k.a facism.

I’ll assume you are what I’d call a true conservative who was against giving GS 100% back on the CDS they bought from AIG, but some warmongers who call themselves “true conservatives” supported the organized theft on behalf of the rich whoheartedly…you know the type…voted for Bush once or twice, liked McCain, thought we had a good reason to attack Iraq and thinks Ronald Reagan defeated communism.

We can both agree socialism is bad mmkay…but it we must have it please lets not have just socialism for the powerful, because that is pretty close to facism and it doesn’t seem to be much fun either.

26 mulp January 18, 2010 at 3:22 pm

What year did Congress pass the Indian Removal Act?

Long before I was born.

But apparently recent enough that it is a fresh memory for you.

Gosh, how I wish I could go back and have every wrong against me and my ancestors righted, all the way back to … Africa!

But the question you failed to answer is “when did Congress not promote home ownership by forcing others to pay the price?”

As Congress has from day one promoted home ownership at the cost of others, every program to promote home ownership has its roots in the very founding of the nation, which was in fact the taking of property from English corporations who owned the colonies by English charter.

And by the way, the property of native Americans as defined by treaty and Congressional law was taken most recently on December 8, 2009, by a settlement on a lawsuit for pennies on the dollar because to continue the litigation would means the claimants would be dead before the claims were determined legally given the willful destruction of documents by the government. Assuming Congress agrees to honor this reduced property right…

27 Curt Fischer January 18, 2010 at 3:55 pm

It limits value-destroying foreclosures.

We often hear that foreclosures are value-destroying. “If my neigbhor’s house gets foreclosed, my house is worth less”, etc. But do foreclosures destroy only perceived value or do they destroy real wealth?

If foreclosures mainly act to destroy perceived value, I think the perception of value loss when a foreclosure happens will lessen as foreclosures become more and more common. Also, if foreclosures are destroying perceived value, maybe that’s a good thing anyway.

But I’ve never been a homeowner, and maybe I don’t understand how foreclosures actually destroy real wealth.

28 maherman January 18, 2010 at 4:09 pm

I’m always surprised by the number of commenters vociferously opposed to principal reduction based upon their desire to have purchased a home but unwillingness to do so during the bubble. If their goal is to purchase a reasonably priced home, it seems their opposition to principal reduction is wrong-headed.

Underwater homeowners will not sell because they cannot afford to realize the loss. Assuming they are able to continue to make their current payments and do not want to damage their credit by walking away, they will not sell their home. Their decision not to sell will only serve to reduce housing supply and perpetuate ‘artificially’ increased prices and prevent true price discovery. Those ‘locked out’ of the housing market will continue to be locked out. On the other hand, if these owners are offered principal reduction, they can now afford to sell the house at a ‘reduced’ price facilitating price discovery.

By this logic, I do not expect to see a governmental push towards principal reduction. A central tenet of policy in response to the financial crisis has been to prevent true price discovery in the housing market at all costs so that banks remain ‘solvent’ and the home owning populace remains secure in their ‘wealth’ so that they can continue (or resume) spending.

29 rhhardin January 18, 2010 at 4:39 pm

The government already screwed up rule of law when it blew away the GM bondholders.

I imagine investors are looking for friendlier countries.

30 David January 18, 2010 at 5:09 pm

maherman, I hope you’re not an accountant.

31 maherman January 18, 2010 at 5:27 pm

David, explain to me from the bank’s perspective the difference between principle reduction and a short sale (assuming the new buyer obtains his mortgage from the same bank).

32 babar January 18, 2010 at 6:19 pm

a lot of distressed mortgages are trading at 40% on the dollar — there’s a lot of room for principal reduction once banks take writedowns.

33 maherman January 18, 2010 at 6:33 pm

@babar: Banks holding mortgages on their books are not currently required to mark the value of their held mortgages to the market for securitized mortgages. They won’t voluntarily take large scale writedowns to accomadate principal reduction or they will likely be insolvent.

34 pshrnk January 18, 2010 at 7:45 pm

Almost everyone who buys a new car with primarily borrowed funds is quickly “underwater”. Why no program for them to boost flat auto prices?

35 maherman January 18, 2010 at 9:23 pm

David, I take it you subscribe to Tyler’s point C: “It is evil and unfair.”

The point of my original comment is that a renter “locked out” of the housing market shouldn’t care whether principal reduction is evil or unfair. A renter and prospective homeowner should want house prices to decline. For that to occur, either the homeowner or the bank needs to realize a loss. A prospective home-buyer shouldn’t care who realizes the loss.

36 Brahma January 18, 2010 at 10:02 pm

PQuincy, you’re incorrect, there were a lot of home buyers who were big gainers and who made those gains by gaming the system. Especially in an overheated market like the one I live in, San Francisco, there were scads and scads of people who’d buy something with almost nothing down, and before they even made six months worth of payments, would do a cash-out refinance, then make the next several months payments with the cash they took out. Then, they’d sell the house at a profit, and then put the proceeds down on another house that was more expensive. This would go on and on to the point that there were lots of people “making” six figures per year flipping properties in this manner.

This does not excuse the behavior of mortgage brokers, but there were people who made out on the real estate bubble, and for the moral logic of capitalism to still have some kind of sway (even on this, a libertarian rational-choice-oriented blog), those people simply must suffer the full and unvarnished consequences of their actions. If they don’t, then they’ll just do it again. If we belive that people respond to incentives, then writing down the principal on mortgages rewards just the people who simply must be punished if the capitalist system is to work.

37 Brahma January 18, 2010 at 11:34 pm

Put another way, the market signals to the various flippers, speculators, and dogy mortgage brokers who have been slinging no-doc loans, in addition to the home debtors who purchased houses with little or nothing down, have not been getting through to their intended recipients. Writing down the principal on mortgages will prevent that from happening.

The home debtors who are about to be foreclosed upon need to get out of their homes and move on to a new life of renting, whereupon they can ponder the error of their ways buy buying into a bubble, so that they don’t make the same mistake again. The foreclosed homes can be sold to the people who were prudent, lived within their means and waited until they had a substantial down payment and prices were affordable to them. Tyler Cowen knows that this is what must happen for any capitalist marketplace to actually work. Twelve more months of foreclosures is really not a high price to pay at all.

38 Ryan Vann January 19, 2010 at 9:29 am

If the issue is one of cash flows, seems to me one remedy would be longer repayment periods (say 40 years).

PQuincy,

Excellent post. Having worked for a financial firm with major subprime issues, I can attest to the institutional path dependence you outline. I think part of the hesitance about re-structuring loans was setting a bad precedence. With that said, most of the hesitance was a result of rigid rules. I do disagree with your assumption about documentation. My company had a pretty extensive debt to income underwriting process (loan officers themselves would verify income from a W-2 and contact current employer to verify the applicant was still working there, we also entered all debt payments into a spreadsheet). When people started losing jobs though (my county was in the 20% UE range) no amount of underwriting made any bit of difference.

39 Tony January 19, 2010 at 1:34 pm

The easiest thing to do is allow principal to be written down in bankruptcy court.

That way, both parties have an incentive to negotiate. But you don’t have to have the government actually step in and do it.

40 Bill Sundstrom January 20, 2010 at 1:01 am

See this paper by my colleague Sanjiv Das.
http://algo.scu.edu/~sanjivdas/loanmod.pdf

41 Piper January 20, 2010 at 2:30 pm

Pedro, (please hear jocular tone; no insult intended…) if you planned for the price of that house to go up, sure, you’re a speculator.

More to the point, your story is very rare. The large majority of house-buyers after 2005 in bubble areas put little or no money down, and many of them couldn’t even afford to pay off their loans on a fully-amortizing schedule– they signed up for “option ARM’s” and so-forth to “buy” houses they couldn’t afford on their incomes, and made desultory payments resulting in “negative amortization” because they expected rising prices to cover the gap. The “cash-out refi” crowd behaved even worse. Surely we agree that all of the above were “speculators.”

The “teaser rate” and “neg am” “buyers” often committed, with their mortgage brokers, outright fraud by lying about their incomes on their mortgage applications. Why did they do that? They were speculating on housing appreciation.

That’s why people like me, who sat out the bubble and would now like to buy a house at a reasonable price are so very angry at the multiple schemes by the Federal government to prop up housing prices (so banks won’t have to write down their bad investments). From our point of view, all schemes to relieve the speculators who ran up housing prices are outrageous ripoffs– why should we prudent folk pay to keep speculators in fancy houses which they got into only by some combination of overconfidence and outright fraud?

I feel sorry for you. I’m quite willing to call you a hard-luck case rather than a speculator. But as a matter of broad-brush public policy, I think any “negative equity” subsidy should be conditioned on the recipient vacating the property so it can be sold immediately at a reasonable price. I don’t want my tax money used to forestall sales or prop up prices any longer. Relief which leaves the recipient in possession will clog the housing market, not free it up.

Also, I don’t want my tax money used to reward speculators’ bad judgment by leaving them in possession of houses which they mostly couldn’t afford when they moved into them. I don’t mind gamblers, but it’s not my responsibility to make up other folks’ gambling losses.

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