Arnold Kling  

Advantages of Mortgage Loans with Recourse

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The Washington Post has a long piece on foreclosure backlogs.

For a solution, I favor the Canadian system, in which mortgage loans are recourse loans. That is, if the lender cannot recover the mortgage amount by selling the house, the lender can go after the borrower's other income and assets.

Recourse loans really change the incentives around foreclosures. As a borrower, you don't want drag out the foreclosure process, because while you do your unpaid interest keeps piling up, and you are now personally liable. So if, as a borrower, you know that you are not going to become current on the mortgage, your incentive becomes the same as the lender--get the property sold as quickly as possible. With recourse loans, you would not even see so many foreclosures. Instead, borrowers would sell the properties.

Another big advantage of recourse loans is that borrowers would no longer think that the name of the game is to buy the biggest house with the lowest down payment. So you would see fewer risky loans in the first place.


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COMMENTS (19 to date)
bill shoe writes:

Recourse loans make sense. As usual the problem is mostly political.

California is a no-recourse state IF the mortgage being defaulted on is the original mortgage that was used by the occupant to buy the house. However, during the bubble almost all California mortgage holders heloc'ed themselves into oblivian, so legally almost 100% of California defaults are recourse.

I follow several California blogs about real estate and foreclosures and have read brief descriptions of 100's of these situations. I have read extreme examples of "homeowners" taking the heloc money and running. I have never heard of a recourse being excercised. I think the banks would have political hell to pay if they started enforcing recourse.

Kevin Waterman writes:

Question with regards to recourse loans. Such a change would unquestionably create a strong incentive for borrowers to sell rather than default.

However banks are already notorious for taking forever to process short sales. Wouldn't such a shift potentially created added incentive for banks to drag the process out even longer since they aren't restricted to just a house that likely won't sell for the amount they're owed?

Eric Morey writes:

Could recourse also help relieve the moral hazard and agency problems that exist in corporations?

There's an overlooked symmetry. If borrowers with recourse mortgages would see more risk and thus be more hesitant to borrow, then lenders with non-recourse mortgages would see more risk and thus be more hesitant to lend.

Joe writes:

A recourse loan also makes predatory lending easier.

Why not let the lender and borrower decide what type of loan they should have? Lenders could lower the rate for a full recourse loan....

Just saying...

Lord writes:

Should we also ban LLCs as contrary to public purpose then? Your argument is also dubious with respect to mortgages. The opportunists fled the market in the first years when mortgage forgiveness taxability was waived. It was the suckers holding on desperately to what they could not afford and making payments for as much as long as they could to keep it. Most of these were NINJA loans that recourse would have never had any effect since there was never anything to go after. Speeding up foreclosures would increase price volatility as owners would have to make their own projections as to whether they might be able to weather a fluctuation or sell before a downturn to avoid one. The data seem quite clear recourse didn't, doesn't, and wouldn't matter because it requires forward projections that humans are very bad at when the future is not like the past.

Alex Godofsky writes:

Even ostensibly recourse loans are frequently non-recourse in practice due to the difficulty of actually going after the borrower's assets. The practical effect is that those with assets that would be easy to seize are subsidizing those whose assets would be difficult to seize (relative to their value).

I'd favor non-recourse loans in general to make this explicit.

Kevin writes:

I'm for non-recourse loans for people who can and want to meet the terms required and recourse loans for people who can (or want) only to meet those lesser terms. It seems wrong that some states prohibit recourse loans. Do states prohibit non-recourse loans?

If there was a real market for mortgages, consumers could choose recourse or non-recourse if they could qualify, and it would be the job of the bank to properly price the products. As some commenters have pointed out, there's a chance that banks would misprice the loans, but that's just part of the competitive process.

Æternitatis writes:

I agree with Prof. Kling. State law should permit recourse mortgages.

I also agree with @Eric Morey. But even under a so-called recourse regime, I do not believe that any state actually prevents lenders and borrowers to agree to non-recourse. If it did, that would be easily circumvented using an LLC (or equivalent). Such borrowers would have the advantage of non-recourse, but probably would have to pay a little higher interest rates or require larger down payments. Risks and prices would be shifted a little, but that is as it should be.

Turning currently non-recourse mortgages into recourse retroactively would be a significant legal problem and is arguably unfair to current non-recourse borrowers who may have (and under economic logic, would have) paid higher interest rates for the non-recourse privilege.

But going forward, recourse mortgages (i.e., permitting them, but allowing them to be contracted around) is clearly the best economic solution. The problem is, as almost always, political, both in implementing it legislatively and the political backlash against already-hated lenders if they tried to use recourse.

Æternitatis writes:

@Kevin Waterman

Banks may or may not be trying to drag out short-sales (not true in my anecdotal experience, but that is hardly dispositive).

But if they do, one of the main reasons would be that they have to eat all the losses of a short-sale in a non-recourse state. Going to recourse, would also substantially reduce the incentives for banks to drag out short sales. If the owner agrees to it, is liable for the shortfall, and able to pay for it in the long run, banks have no reason to delay short sales.

Jim Rose writes:

Not being from the USA, when discussing the U.S. housing crisis with others, I have to explain carefully, and over and over again, the notion of a non-recourse mortgage.

Few, and no matter how far to the left, can comprehend the notion that people who default on mortgage debt cannot in the end, lose other of their assets in addition to the home to repay and even go bankrupt.

No matter how far to the left, they think that a non-recourse mortgage is bizarre and encourages bad borrower behaviour.

Once non-recourse mortgage are understood, the understanding of those I am talking with of the true causes of the U.S. housing crisis does change.

Nathan Smith writes:

Ah, the distortions that come from making homeownership part of the social contract.

Presumably, the crisis will curtail the implicit subsidies to homeownership to some extent. I wonder if that will lead to less sprawl, more European-style urban living. I think the age of internet and cell phones is kind of conducive to that anyway. Cell phones make it easier to meet up with people in the city, and internet allows you to pack more entertainment into a small space. A big house and yard start to seem like white elephants.

However, that leaves us with a big overhang of housing we can't use. Not sure what happens to us if we stay too dumb to let in more immigrants to live in it.

Jaap writes:

but wait!
bubbles occurred in both recource and non-recourse states... also, Canada is fully recourse, but right now, we are in the same bubble, just a few years later. if you want to contest this, try buying a home in Vancouver. I checked out zillow for SF, and was dumbfounded by the low prices there!
please check your facts before posting dr. Kling.

Wanted-to-be-Short-Seller writes:

We tried to short sell our home instead of letting it go into foreclosure. We had all the leverage to just walk away, but it was literally impossible to short sell because of the Bank. The people managing the process at the bank are somehow complete idiots who don't have the bank's interests at heart. That's the only explanation I can give other than "Accounting rules/regulations made them do it".

The bank had zero leverage because we already owned a new home (with a 100% mortgage, so no assets) and didn't live in the old one anymore. Did anyone at the bank recognize that? No.

First, we couldn't get them to consider a short sale at all without defaulting first. I'd have been happy to make the payments while doing the short sell, but the Bank refused to consider that procedure. Apparently they didn't want the extra money.

Second, over a few months, we brought them two different buyers who were willing to pay $150K for the home. The bank refused to approve, wanted 180K based on their "expert" appraisal. We had paid $169K for the house in the first place and finished the basement for another $25K, but prices were different then. In between the appraised value hit $320K and we had a $250K loan.

Ultimately they foreclosed. A year after they could have short sold the house for $150K, I've finally seen it on the market from them, but listed at $69K.

Sure, they didn't want to lose $100K on the loan at first, but by then it was clear prices weren't going back up anytime soon. They ended up losing at least $200K (and probably more) instead, so why not do the Short Sale?

Still doesn't make any sense to me.

Wanted-to-be-Short-Seller writes:

Forgot to add about the foreclosure process... when they went to foreclose, they sent us notice after notice... about a foreclosure in some other jurisdiction related to someone else's property.

They never did properly send us a single notice. We could easily have fought the foreclosure and kept possession of the house for a lot longer, but by then we just wanted to get rid of it. I couldn't afford to keep two houses long term and couldn't find work closer than 800 miles away, which makes for a long commute.

If they had just said, "We'll take it!" I'd have signed it over to them in a minute right at the start of the whole process, but they have to follow their screwy procedures.

At least at this specific bank, the people have no idea what they are doing, but apparently they get paid to do it...

Æternitatis writes:

@Wanted-to-be-Short-Seller

It certainly sounds like in your case the bank employees did not act in the bank's interest, even as you were trying to do the best you could in everybody's interest.

But as you said, the reason is either (a) the employees just being stupid, in which case the owners of the bank took a well-deserved hit for instituting stupid procedures or hiring idiots or (b) they were forced to act that way by law or regulation, in which case the blame really belongs with the law makers or regulators, not the bank.

Naoto Odagiri writes:

Here in Japan, all the housing loans are recourse loans. The borrowers are carrying a heavy burden.

We hear such system as a "jingle mail" exists in the US. I understand it will negatively affect your credit record, but you still have an option. In Japan, your debt obligation never disappears unless you are legally bankrupt.

Even when an earthquake/tsunami completely destroys your house, you have no option to relinquish it to the lender. Many families end up shouldering "double loans", ie, loans for the old (not-livable) and new houses. Most people don't bother to take out earthquake and tsunami insurances because they tend to be very expensive in a disaster stricken country.

regular guy writes:

Why not mandate 10-20% cash down payments along with a keys in lieu of foreclosure system? The buyer had real cash to lose, the bank has an interest in real valuations, and the cost/time of foreclosures is saved. I understand from old timers that that is how the banking industry actually worked before "too big to fail" megabanks. Also mandate that the originators of the mortgage continue to hold part of the note. FWIW I would add no employees of banks which fail can ever be employed in financial services again.

wannabe writes:

How does this work in a world where lenders paid and/or blacklisted appraisers:

http://en.wikipedia.org/wiki/Blacklist#Real_estate_appraisers

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