Tuesday, November 18, 2008

Ownership* Society

Martin Feldstein -- professor of economics at Harvard and recently an adviser to John McCain and a director of AIG -- tells Wall Street Journal readers of his proposal to unlock the US housing market:

The key to preventing further defaults and foreclosures among current negative-equity homeowners is to shift those mortgages into loans with full recourse, allowing the creditor to take other property or a fraction of wages. But the offer of a low-interest-rate loan is not enough to induce a homeowner with substantial negative equity to forego the opportunity to default and escape the existing debt. Substituting a full-recourse loan requires the inducement of a substantial write-down in the outstanding loan balance.

In less technical jargon, he wants negative equity mortgages -- where the value of the house is currently less than the value of the loan -- to have the "walk away" option removed (where one can turn in the keys without being liable for the shortfall) and replaced by a lower value mortgage where the lender can come after the homeowner for any additional shortfall if a further negative equity situation developed down the road. The government and the lender would split the loss on the difference between the old and new mortgages.

Here's the problem. If full recourse mortgages worked so well, you'd think the UK housing market would be looking like a good role model for Feldstein's scheme. It's not. There's still lots of negative equity. All that happens under the full recourse mortgage is a different set of unpalatable choices.

Now lenders can repossess the house and chase after borrowers for the loss in value. So to avoid that, the borrower does some or all of: staying in the house watching the arrears pile up, resisting moving to somewhere else with better job prospects since the mortgage has them chained down, dumps the house onto the rental market, or gambles that the legal and political difficulties of large scale repossessions will let them keep the house for an extended period of time. All of which leads to a huge overhang of potentially distressed houses on the mind of the housing market.

And that's not the end of it. Once you introduce the idea that US mortgage lenders can seize other property or wages to settle a mortgage, all the other lenders who thought of that as their lead option start to panic. Does the credit card company now rush to get an order taking some percentage of the borrower's wages before the mortgage bank gets there first? And, if like many US households with negative equity, your home is in some godforsaken development in California, Michigan, or Florida, why would you give up the right you have now to walk away?

In short, there's no magic rewriting of mortgage contracts that will solve the problem. It has to be done at source: the economic circumstances of the people stuck in these mortgages.

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