Arnold Kling  

My Mortgage Plan, Continued

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My latest essay elaborates on my debt-equity swap idea.


The swap is in some ways a compromise between two other mortgage relief plans. Dean Baker would have homeowners give up all of their equity and become renters. Steven Pearlstein would have the size of mortgage loans reduced to what the borrower could presumably carry using standard income guidelines.

The Baker plan strips homebuyers of their asset in order to remove their mortgage liability. He thinks that homebuyers are victims of a bubble, and somebody else needs to bear the cost. The Pearlstein plan gives buyers a reduction in their liability in exchange for nothing. He thinks homebuyers are victims of aggressive lending, and somebody else needs to bear the cost.

The swap plan treats homebuyers as adults who made grownup decisions. It says that they can stay in their homes, but they have to give up some of their equity in order to do so. However, unlike the Baker plan, they do not have to revert to becoming renters.


We're seeing a lot of stories these days that X percent of troubled mortgages are investor loans and Y percent are cash-out refinances. If most mortgages used to purchase owner-occupied homes are not in trouble, then I would expect lenders to be willing to make such loans, so that the housing market itself would remain reasonably liquid. My guess is that in fact there are plenty of owner-occupied purchase loans in trouble, also. But it would be useful to have the data.

I still think that the big issue here, if any, is the overall trust in financial intermediation. We've enjoyed very low risk premiums across the board for several years, and if all of that were to unravel there would be widespread effects on investment. I do not see any reliable way to predict how long or how widespread the damage will be to confidence in financial intermediaries.


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COMMENTS (7 to date)
shayne writes:

I see a very plausible set of circumstances for which this type of plan would provide additional motivation for marginal buyers to become loan non-performers, further aggravating the problem. Perhaps I'm missing something.

Consider the crop of owner-occupied marginal buyers who purchased a home at, or just before, the peak of the housing market. They are motivated to try to keep their homes but they have already seen their equity stake degraded by the decline in the market. The proposed "equity swap" would further erode their equity stake and their motivation to keep making payments.

If I were one of those types of buyers - not quite able to make current payments, or not able to make the post-ARM adjustment payments - AND I saw that the home I bought for $300,000 a few months ago currently has a market value of $250,000 AND the loan agency says I can keep the home with an "affordable" payment structure IF I give up more equity, I'm going to give them the keys back.

In order to restore liquidity in the financial markets, lenders are going to have to restore performing payments streams. And they will have to do so realizing housing market realities, just as buyers do. This isn't "revenge" against the "bad old lenders", it is merely a market adjustment that will have to be assimilated by both sellers/lenders and buyers. Even currently performing buyers have seen their equity stake decline as a result of the decline in market values. I'm not convinced that a plan based on further erosion of equity stake for marginal buyers is a solution.

Matt writes:

"Between late 2001 and this summer (2007)," says the (NY) Times, "the average rent per square foot fell 4.8 percent across the country, according to the National Real Estate Index, which is published by Global Real Analytics, a research company."

If I can trust Realty Times at
http://realtytimes.com/rtcpages/20031202_rentalrates.htm

But, as Schiller reported, the Bureau of Labor CPI index does not show this drop? How is this?

I would trust Realty Times over the government agency, which I suspect of bias in its CPI calculations. If I analyzed the cause of the discrepency, which I haven't, I would look at the Bureau's rental equivalence formula in times of rapidly rising housing prices, and see if the lower number of detached house renters biases the calculation.

In any event, if you believe Realty Times, then housing has been undergoing undergoing actual deflation, and rental units are a leading indicator. Yet during that same period, owner occupied had its large gain and Bernanke worried about inflation! What a contradiction!

My best explanation is the five year lag between inflation and inflation expectations. My guess is that in a few months, the Bureau will look back in hindsight and say a downturn started a few quarters ago.

Arnold Kling writes:

Matt,
the article from realty times is from December of 2003. So I think we need more recent data to support the notion that rents have been falling.

Fritz writes:

I find it troubling when free market economists offer government programs. When did it become official that the US real estate market is not capable of 1mm+ foreclosures a year? I received a letter in the mail that says, "Tap your equity today before home values decline." The "crisis" appears to be located in the upper east side of Manhattan not main street.

ErikR writes:

The $64 thousand dollar question:

Why does only $62,000 from the homeowner/borrower go to paying of the loan? Shouldn't it be $64,000?


"For example, suppose that the outstanding balance at the time of the swap is $100,000, and the borrower's monthly principal and interest is $800. With the swap, the borrower's monthly principal and interest payment would drop to $640, and Bailie Mae would pay $160 per month.

Several years later, the borrower gets a job in a new city and sells his home. By this time, the outstanding loan balance is, say, $90,000. Bailie Mae is responsible for 20 percent of that, or $18,000, with the borrower responsible for the remaining $72,000. If the home sells for $110,000, then 20 percent of that goes to Bailie Mae, which means $22,000. Another $72,000 is used by the borrower to pay off the loan, leaving $16,000 to go to the borrower.

Suppose that the house is sold for only $80,000. In that case, Bailie Mae gets only $16,000 even though it still has to pay $18,000. The borrower gets nothing, and $62,000 goes toward paying off the loan. The cost of the remaining $10,000 shortfall in paying back the loan is borne by the responsible lending party--perhaps a bank, perhaps a mortgage insurer, perhaps another financial market participant involved in trading credit derivatives. If there are large, widespread losses, they will be borne mostly by the original investors, and only somewhat by Bailie Mae.

Matt writes:

Whoops, I looked at the date of the magazine not the date of the article!

Josh writes:

Arnold, why stop at mortgages? I wonder if this isn't a whole new way to handle government assistance programs. Right now, the government pretty much gives you something for nothing (welfare, subsidies, etc.). If the government is going to do something (and it always does something), why can't it always offer these something for something options? For example tariffs - if you enact a tariff to protect an industry, increase the corporate profits tax on that industry to make it as neutral as possible for the companies and the American people.

Or with education. Instead of giving out scholarships (or even vouchers for elementary and secondary education, if we ever get there), give the scholarships/vouchers in exchange for, say, a 10% surtax on every dollar earned over some minimum (maybe the median salary ~$30k) until the debt is repaid. That way, the government recoups ~half of the money it spent and people aren't just getting a handout.

I would prefer the government didn't give handouts, but at least if it's one of these something for something options, it's more like an investment by the American people. And it seems like it has a better chance of getting passed because it's a compromise.

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