Saturday, 14 February 2009

Don't let judges tear up mortgage contracts

Todd J. Zywicki, professor of law at the George Mason University law and a senior scholar at the university's Mercatus Center, has an article in the Wall Street Journal in which he says, Don't Let Judges Tear Up Mortgage Contracts: That's the last thing troubled securities markets need. One could go further and suggest not letting ministers or the leader of the opposition tear them up either.

Zywicki opens his piece by saying
The nation faces a foreclosure crisis of historic proportions, and there is an understandable desire on the part of the federal government to "do something" to help. House Judiciary Chairman John Conyers's bill, which is moving swiftly through Congress (and companion legislation introduced by Sen. Richard Durbin) would allow bankruptcy judges to modify home mortgages by reducing both the interest rate and principal amount on the loan. This would be a profound mistake.
Take note politicians. Zywicki continues
In the first place, mortgage costs will rise. If bankruptcy judges can rewrite mortgage loans after they are made, it will increase the risk of mortgage lending at the time they are made. Increased risk increases the overall cost of lending, which in turn will require future borrowers to pay higher interest rates and upfront costs, such as higher down payments and points.
He also notes that incentives matter,
Allowing mortgage modification in bankruptcy also could unleash a torrent of bankruptcies. To gain a sense of the potential size of the problem, consider that about 800,000 American families filed for bankruptcy in 2007. Rising unemployment and the weakening economy pushed the number near one million in 2008. But by recent count, some five million homeowners are currently delinquent on their mortgages and some 12 million to 15 million homeowners owe more on their mortgages than the home is worth. If even a fraction of those homeowners file for bankruptcy to reduce their interest rates or strip down their principal amounts to the value of their homes, we could see an unprecedented surge in filings, overwhelming the bankruptcy system.
Zywicki also notes that the law of unintended consequences could come into play,
Finally, a bankruptcy proceeding sweeps in all of the filer's other debts, including credit cards, car loans, unpaid medical bills, etc. This means that a surge in new bankruptcy filings, brought about by a judge's power to modify mortgages, could destabilize the market for all other types of consumer credit.
But there are other problems,
A bankruptcy judge's power to reset interest rates and strip down principal to the value of the property sets up a dynamic that will fail to help many needy homeowners, and also reward bankruptcy abuse.

Consider that the pending legislation requires the judge to set the interest rate at the prime rate plus "a reasonable premium for risk." Question: What is a reasonable risk premium for an already risky subprime borrower who has filed for bankruptcy and is getting the equivalent of a new loan with nothing down?

In a competitive market, such a mortgage would likely fetch a double-digit interest rate -- comparable to the rate they already have. Thus, the bankruptcy plan would offer either no relief at all to a subprime borrower, or the bankruptcy judge would set the interest rate at a submarket rate, apparently violating the premise of the statute and piling further harm on the lender.
Zywicki sees as more worrisome is the opportunity for abuse.
Imagine the following situation: A few years ago a borrower took out a $300,000 loan with nothing down to buy a new house. The house rises in value to $400,000, at which time he refinances or takes out a home-equity loan to buy a big-screen TV and expensive vacations. He still has no equity in the house.

The house subsequently falls in value to $250,000, at which point the borrower files for bankruptcy, the mortgage principal is written down, and the homeowner keeps all the goodies purchased with the home-equity loan. Several years from now, however, the house appreciates in value back to $300,000 or more -- at which point the homeowner sells the house for a tidy profit.
But sill other problems could arise as any modification of a mortgage during bankruptcy will almost certainly increase the losses of mortgage lenders, and this may further freeze credit markets.
The reason is that when mortgage-backed securities were created, they provided no allocation of how losses were to be assessed in the event that Congress would do something inconceivable, such as permitting modification of home mortgages in bankruptcy. According to a Standard & Poor's study, most mortgage-backed securities provide that bankruptcy losses (at least above a certain initial carve-out) should be assessed pro rata across all tranches of securities holders. Given the likelihood of an explosion of bankruptcy filings and mortgage losses through bankruptcy, these pro rata sharing provisions likely will be triggered. Thus, the holders of the most senior, lowest-risk trances would be assessed losses on the same basis as the most junior, riskiest tranches.

The implications of this are obvious and potentially severe: The uncertainty will exacerbate the already existing uncertainty in the financial system, further freezing credit markets.
In summary,
If Congress wants to deal with the rising number of foreclosures, it should not create a new mess by converting the mortgage crisis into a bankruptcy crisis. Doing so will open the door to a host of unintended consequences that will further freeze credit markets, raise interest rates for new home buyers, and spread the mortgage contagion to other types of consumer credit.
The logic of this applies outside of the US. The problems Zywicki identifies would arise if politicians attempt to interfere with mortgages even in countries with different legal rules.


Bill Bost said...

It is interesting to me that the banks object so loudly. They are not lending their own money anymore. And bankruptcy cramdowns will not likely be common enough to have the far-reaching effects that the banks are worried about.

What the banks are really worried about, I think, is the increased leverage that borrowers will have in modifying their loans. Right now, the banks can take a "Take it or leave it" approach to modifications. If the cramdown legislation passes, then borrowers will be able use the threat of bankruptcy to negotiate more favorable terms. While there may be losses, modifications of salvageable loans will occur with or without cramdown or stimulus of federal aid. The question is "On what terms?"

John Macilree said...

Paul, in this context I would be interested in your thoughts on some economic history - mortgage "relief" in 1930s New Zealand.

Paul Walker said...

John: The short answer is that I don't know much on this. But I will check into it. Fiscal policy in general, it appears, didn't play much of a role in getting NZ out of the depression. As I noted here monetary policy was the main driver.

Paul Walker said...

John: The following comes from a paper by Grant Fleming on "Economists and Mortgage Relief in New Zealand in the 1930s", Australian EconomicHistory Review, Vol. 37, No. 1 March 1997, pages 54-68.

Economic debate onmortgage relief during the 1930s depression yielded two possible relief measures. On the one hand, Barney Murphy, professor of economics at Victoria University College, advocated a non-interventionist
stance by arguing that greater social damage could be caused by breaking mortgage contracts than by observing them. Government alteration of contracts would increase private sector uncertainty and hinder any possible recovery in agriculture. On the other hand, Professor Horace Belshaw of Auckland University College applauded Adjustment Commissions' efforts to negotiate new terms and agreements between mortgagors and mortgagees. For Belshaw, lower interest rates were concomitant with recovery in the farm economy.We should note that both economists highlighted the importance of the State in creating an economic climate conducive to increased agricultural investment as a precondition for recovery. In essence, Murphy championed business confidence and expectations of future farm income as the most influential factors in farm investment decisions while Belshaw stressed the need for lower interest rates if farmers were to trade out of their difficulties.

MacDonald and Thomson are right to maintain that Adjustment Commissions were important in popularizing the view that domestic, as well as international, factors contributed to the `rural crisis'. But the Commissions were far from path breaking in coming to grips with the underlying causes of rural depression.The basic principles of many of the Adjustment Commissions' edicts can be located in early Canterbury theorizing on farm finance and land values. As early as 1923 Condliffe and Belshaw had stressed that land values should reflect productive value, that long-term finance was desperately required to satisfy the peculiarities of farmers' financial requirements, and that interest rates needed to be flexible and reflect changing market conditions.

Finally, this paper has raised some problems with interwar policymakers' views on the necessity of nominal interest rate flexibility for an efficient agricultural finance system; problems that are important to bear in mind in current policy formation. Official advisers, Belshaw included, failed to distinguish between farmers' nominal and real mortgage costs in tendering advice on the establishment of the Mortgage Corporation. Indeed, an apparent lack of understanding of the behavioural variables important during the 1920s and 1930s in determining agricultural investment led to an overemphasis on State remedies.While perhaps justifiable as a crisis measure, State interference in private sector contracts and the provision of concessionary loans did little to offset negative farmer expectations and encourage investment.

Paul Walker said...

Gary Hawke in his "The Making of New Zealand: An Economic History" has this to say

Reduction of interest rates could be seen as part of the deflation needed to bring internal costs into line with overseas prices, or as part of the package of measures recommended by the Economists' Committee to achieve equality of sacrifice, or as the implementation of cheap money. The underlying reasoning differed and was not always compatible across different lines of advice, but the recommended measures were clear and were adopted by the government. Interest rates on new issues of government stock and, with the agreement of the banks, on overdrafts and fixed deposits, had already been reduced in 1931. In 1932, more steps were taken. A Mortgages and Tenants Relief Act extended the modification of mortgages to include those not secured on farmland and made it possible for the mortgagor to initiate renegotiation of terms even before a mortgagee attempted to enforce a power of sale. The National Expenditure Adjustment Act provided for a 20% reduction in interest rates and rents provided that they need not fall below a floor (of 5% or unimproved value in the case of rents, 6$% for interest rates on loans secured on chattels, 44% on debentures of free of income tax, and 5% on other debentures, mortgages and preference shares). The sanctity of private contracts was overridden but, while this stimulated some opposition in the 1935 election, the government's decision was that it was more important to attempt to counter the Depression. Government stocks were converted to lower rates by the simple expedient of imposing an additional tax on the interest of any shareholder who declined to convert 'voluntarily' to the new issue. Overdraft rates were reduced again, with the government according to Sutch, threatening to legislate if the banks refused to do so voluntarily.

John Macilree said...

Thanks Paul. I recall in the 1970s an elderly relative still being very sore about what had been done.

Anonymous said...

Can't bankruptcy judges adjust other debts and their repayment schedules etc? Why should banks be any different?

If banks were to gain the impression that sometimes when they loan out money it might not come back, they might become less adventurous.

toronto real estate said...

So what you are saying is that the majority should not be allowed to file for bankruptcy? But how are people that just lost jobs - and often both both of the couple - supposed to pay the mortgage? I think there's no win-win situation. The whole system needs to be changed and it'll be a painful process. And before the new system is in place, people will continue to lose houses and banks will have to be controlled to some degree.