Arnold Kling  

The Kling Plan for Mortgage Forbearance

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Steven Pearlstein writes,

The Pearlstein workout process starts where things should have started in the first place -- with the household income of the borrower. Using standard formulas, figure out how much they can afford to pay each month toward interest and principal on a fixed-rate, 40-year mortgage. Then, adjusting for credit score, calculate how large of a mortgage those payments can support.

I think that adjusting loan balances based on borrower characteristics is a bad idea. First, the calculations are imprecise. Second, it gives the borrower equity in the home that he does not deserve.

Instead of the Pearlstein plan, let me suggest the Kling Plan (but keep in mind that I have not put much thought into this): reduce the size of the mortgage to what it "should have been," but calculate "should have been" based on a 20 percent down payment. Also, do the reduction as a debt-for-equity swap.

Suppose we have a single lender, and an outstanding mortgage balance of $100,000 on a home that was purchased for $100,000. The lender would reduce the size of the loan to $80,000 in exchange for 20 percent equity in the home. Down the road, if the borrower sells the house, the lender gets 20 percent of the proceeds. Meanwhile, the borrower has a lower payment and can avoid foreclosure.

In the real world, there is more than one party bearing the risk of mortgage default. For example, suppose that the lender has mortgage insurance for $10,000. How should the mortgage insurance company compensate the lender for the latter's debt-equity swap? Two possibilities:

1. The insurer immediately pays a $10,000 claim to the lender and in return receives a 10 percent equity stake in the house.

2. Nothing happens until the house is sold. At that point, if the lender receives more than $10,000 but less than $20,000 for its equity stake in the house, the mortgage insurer is responsible for meeting the shortfall. If the lender receives less than $10,000, then the insurer is responsible for $10,000. If the lender gets more than $20,000, then the mortgage insurer is off the hook.

Suppose that instead of mortgage insurance there are two loans on the house--one for $90,000 and a second one for $10,000. Do you reduce the first loan to $80,000, eliminate the second loan, and give each lender a 10 percent equity stake? Or do you treat the second lender more like a mortgage insurer?

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shayne writes:

Before coming up with solutions, I suspect we would be best served completely understanding the problem. I've noted that all of the recent discussion on this has centered around "poor families" being suckered by unscrupulous lenders and lending practices. I strongly suspect that is not entirely the case. I would like to see what percentage of current defaults are attributable to "poor families" who can't make their mortgage payments versus speculators who won't make their mortgage payments. Consider the following two examples:

Example 1.) Sam Shmuck, by virtue of the mortgage community's creative financing, finally gets to "qualify" for home ownership. With a bit of bad judgment on Sam's part and on the lender's part, Sam signs onto $1,000 per month payments (blossoming to $1,200 per month a year or less later when the ARM kicks in) when he can actually only afford $800 per month in actual outlays. Everyone wins (sort of) - Sam gets a new home, the lenders get their fees, interest, etc. - UNTIL Sam realizes he really can't make the current, let alone the increased payments AND if the mortgage holder forecloses, the house isn't worth even the principal originally loaned to Sam.

Example 2.) Joe Smith already owns a home that he and his family occupy. He observes the housing price inflation occurring during recent years and decides to get in on the deal. Ordinarily, he couldn't qualify for another home loan - no down payment money and already carrying a mortgage payment. Fear not, the lending community devises the "no-down, interest only ..." sub-prime instrument to allow Joe to buy another property and "flip" it at a later date. Everyone wins - Joe gets the proceeds of the house inflation, the mortgage company/financial institution get fees and interest, etc. - UNTIL the housing prices begin to deflate, rather than inflate.

Now consider the incentives. In both examples, the buyers quit making payments - Sam because he can't and Joe because he won't. Joe is better off cutting his losses and just sending the keys to the house back to the mortgage holder instead of the payments. Note Joe already "owns" the home he is living in, so any degradation in his credit rating won't matter. Sam, on the other hand, actually wants to own the home, he just can't make all of the originally agreed upon payment.

Note that the mortgage holder really doesn't care which example is the case - they just see the non-performing loans. They don't want the collateral (properties) back because they can't re-sell them into the current market without incurring an enormous loss. But there is at least a partial win-win market-based solution available in Sam's case - re-negotiate the terms of Sam's loan such that Sam really can afford to be a home owner and the lender at least restores a substantial part of their revenue stream. In Joe's case, the lender has merely gotten stuck with the risk they assumed to begin with - they still own the collateral, they'll take a loss "flipping" it in the current market, but that is the nature of risk.

I suspect there are far more "Joes" than "Sams" out there contributing to the current default rates, and I'd like to see actual statistics on the ratio before devising or implementing any "solutions".

Matt writes:

I like it, I call that property banking, as opposed to inflation banking.

My newest stab at this is time series shifting of mortgage payments. A high risk borrower can lock in an interest rate today for a loan some months hence. He begins mortgage payments today.

liberty writes:

1. In this country we love to give people equity they don't "deserve." That is the purpose of the FDA loan, along with similar purpose in the farm bill and in other kinds of programs. There are many reasons for this, many of which are covered at this blog regularly.

2. The Sam Schmucks of the world can already renegotiate with lenders, bring in third party lenders, etc. Yes, some of them will kill your credit rating, others will try to hoodwink you into a worse situation, etc. But in general if you are a first time low income home owner in this country and are unable to make your monthly payments, you have a half dozen other options before you have to foreclose.

liberty writes:

oops, that should read FHA loan :)

I don't get why the bank would do any of this. A single lender looking at an outstanding mortgage balance of $100,000 on a home that was purchased for $100,000. The lender owns the whole thing. why not foreclose, sell and put his entire $100,000 to use, instead of getting interest on $80,000 and hoping $20,000 earns a return on appreciation (a terrible investment)?

Second, the current market doesn't resemble your example. The lender already sold the loan, and the current owner thinks he's just holding a security with respect to thousands of homes. That investor is not set up like a local bank branch to engage in a real estate business, which requires local legal services in every place a property is located. (You'd have to record the 20% holding).

Shayne, you can probably find answers here:
seems like less then 40% of defaults happen to flippers.

Telnar writes:

There are some questions about how to end these loans also.

Let's say that the homeowner wants to sell the house for an amount between $80,000 and $100,000 but is unwilling to accept an obligation to continue making payments to resolve the negative equity. This sale might well be in the bank's interest (since the owner could otherwise default, leaving the bank with the same amount minus the transaction costs required to find another buyer). The problem is that this transaction has become extremely difficult to conduct. If the bank makes uses its equity position to block most sales (absent a compelling demonstration that the sale is in the bank's interest), then it's likely to end up with a default. On the other hand, if it approves these sales based on very little information, then the owner has an incentive to sell for closer to $80,000 and receive a side payment from the buyer. It's not clear to me that banks will succeed in finding the right balance of how to use their equity stakes, and the whole thing might become a public relations nightmare for them.

ed writes:

I'm tired of hearing about the plight of "hundreds of thousands of families who will be forced from their homes."

What about the long forgotten hundreds of thousands who are already forced from their "homes" every year...they're called renters. I just don't see why we should be helping the foolish people who bought homes while doing nothing for the equally poor but more prudent renters who didn't. The renters still have to find housing on the rental market, why shouldn't the "owners" have to do the same?

Fritz writes:

Who says the US real estate market is incapable of 1mm plus foreclosures a year? We simply desire an orderly process and should prevent an unnecessary panic. Banks had no problems in the early 90's liquidating their commercial real estate. At First Chicago, we sold our real estate to GE, wrote off $2.3bn. I see no reason why the same for residential investor pooling can't be arranged. The right of equity redemption would take the home off the market for 12-15 months anyway. The cost of carry until equilibrium is what we are negotiating, that price is here, we simply haven't finished the process. The authors idea would encourage more foreclosures by offering the defaulter an incentive to default.

Fritz writes:

I have an even better idea; approve 1,000,000 H1 visas, cause a shift in aggregate demand for residential real estate.

shayne writes:

To Guy ...:

Thanks for the link. I also heard one of the talking heads on CNBC yesterday (Friday) mention something on the order of 25% of the defaults are related to speculators rather than the classical homeowners. I suspect that both are little better than guesses at this point. If there were actual data available, much of the "re-pricing of risk" would be complete at this time, and that doesn't seem to be the case.

Grzesiek writes:

"Suppose we have a single lender, and an outstanding mortgage balance of $100,000 on a home that was purchased for $100,000. The lender would reduce the size of the loan to $80,000 in exchange for 20 percent equity in the home. Down the road, if the borrower sells the house, the lender gets 20 percent of the proceeds. Meanwhile, the borrower has a lower payment and can avoid foreclosure."

Arnold, there seems to be two variables in play in this scenario. One is the appreciation or depreciation of the asset (home) and the other is the time value of the money that is to be awarded to the lender at time (future) of sale.

One can do much more with money if you have it now; time allows the holder of the money the immediate opportunity to earn more interest on that money.

liberty writes:


ah, but we subsidize renters too-- even more than homeowners, according to Urban:

MacDonald Bowden writes:

I think that something needs to be done. But also that when you take a mortgage that is from a company and it sounds to good to be true, you need to take a mortgage with a flat rate and you pay the same amount each month. I don't know how many people are going to lose their house I know that it is in the millions but that will happen in a market like we have today. I like the idea that we have of being able to sell your place instead of it being foreclosed. Someone needs to step up and do something to help these people out or the market wll turn.

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