In 2008, banks commenced foreclosure proceedings on 2.2 million homes. This year could be worse.1 While economists disagree on whether this is the worst economic crisis since the Great Depression, everybody agrees that this is the worst real estate crisis since the Great Depression. Foreclosure is not just a human tragedy, it is an economic tragedy as well. Foreclosed houses are poorly maintained if not looted. As a result, foreclosed properties lose a substantial fraction of their value, between 30 and 50 percent.2 If this was not enough, foreclosure has some very negative spillover effects. Forced sales depress the value of the surrounding properties. When forced sales become frequent, they undermine the value of a neighborhood, pushing other people to sell or default. Finally, widespread defaults reduce the social stigma of defaulting, leading to the possibility of a vicious circle of default causing other defaults, depressing real estate prices further and causing still more defaults.3
The market seems to anticipate this doomsday scenario. Figure 1 reports the price of an index of AAA mortgage-backed securities in the last six months. In spite of the fact that all the components of this index were AAA rated at origination, recent prices oscillate around 35 cents on the dollar. It is hard to make sense of these prices without assuming a contagion effect on default and a large deadweight loss conditional on default.
Even if we were to assume that all securities are backed by mortgages in Las Vegas (which with almost a fifty percent drop in prices is the most severely affected area of the country) and 100% of the underlying mortgages defaulted, the price of this index should not be below 50 cent on the dollar. The holders of securities should expect banks to recover houses worth half as much as the loans, and so the securities should be valued at half their par value. The fact that the securities trade at 35 cents implies that the market expects the houses upon foreclosure to be worth at least 40 percent less than their current market value—and even less than that if (as is likely) less than 100% of the mortgages default.4 Similarly, the fact that to rationalize these prices we need a 100 percent default rate, while even in the worst part of the country we are at 54 percent, implies that the market expects either a large contagion effect or a massive government intervention that forces a debt forgiveness or both.
Since about 10% of the $10 trillion mortgages are currently delinquent or in the foreclosure process,5 the expected deadweight loss for the delinquency started so far will be at least $300 billion or $1,000 per American. Avoiding this loss should be a top legislative priority. A major puzzle is why the market does not avoid these losses. Lenders can do better if they renegotiate loans rather than foreclose on them. To see why, suppose that the outstanding debt on a house is $200,000, the market value of the house is now $150,000, and the foreclosure value of the house is $100,000. If the lender forecloses, it obtains $100,000 at best. Alternatively, it could renegotiate the loan with the homeowner for, say, $140,000. The homeowner now owns a house worth $150,000, and the bank owns a loan worth $140,000. The homeowner could resell the house and obtain a profit for $10,000, or keep the house—in either case, the foreclosure inefficiency of $50,000 is avoided, as are the negative effects on neighboring houses. With millions of houses currently in foreclosure or close to it, the cost savings from loan renegotiations could be enormous. However, if loan renegotiation is desirable from an ex post perspective, it can nonetheless create problems for banks, which must take into account the effect of loan renegotiations for future credit transactions. If borrowers with outstanding mortgages observe that other borrowers benefit from loan renegotiations, then they will realize that they, too, may be able to renegotiate their mortgage if otherwise they would default. If homeowners anticipate the possibility of renegotiation, they might deliberately maintain thin equity margins so that they can credibly bargain for a loan renegotiation if the value of the house declines. As a result, many banks appear to have a policy of either not renegotiating loans or doing so only in unusual circumstances.
Another reason that loan renegotiations are rare is that the transaction costs of renegotiating loans are high when loans are securitized. Few banks maintain the loans on the books that they originate. Loan originators immediately sell their loans to investment banks and other institutions that pool them and then divide the combined stream of principle and interest payments into securities that are sold on the market. The holder of a security receives payments from a particular pool of loans until the debts are paid off. A loan servicer collects mortgage payments from the homeowner and passes them on until they end up in the pockets of the holders of mortgage-backed securities. Thus, when it comes time to renegotiate the loan, the homeowner cannot communicate with the owners of the loans—there are thousands of them dispersed throughout the world—but must deal with the loan servicer.
The loan servicer probably has no financial incentive to renegotiate the loan. It does not lose if the homeowner defaults. The loan servicer may have a contractual obligation to the MBS holders to renegotiate the loan as foreclosure nears, but the MBS holders will usually not be in a position to enforce these rights. Indeed, when loan servicers do renegotiate loans, they face the risk of lawsuits from MBS holders who claim that the loan servicer was too generous to the homeowner. MBS holders today may also believe or hope that the government will purchase their MBS’s, maybe at par or above-market value, and thus prefer to avoid renegotiations that will lower their value. And none of these parties has much interest in ensuring that a borrower’s neighbor’s house maintains its value rather than being dragged down by a foreclosure.6 Consistent with these claims, Piskorski, Seru, and Vig find that seriously delinquent mortgages controlled by servicers of securitizations enter foreclosure much more quickly than portfolio loans.7 One of the great challenges of the financial crisis, then, is to discover a way to ensure that houses are either kept or sold by their owners, rather than foreclosed, when the owners default on their mortgages. The goal is to force a renegotiation between the homeowner and the owner or owners of the mortgage. At the same time, a system that forces such renegotiations should be designed so as to minimize administrative costs and to avoid, as much as possible, negative ex ante effects on the cost of credit.
In this paper, we propose a plan that will help reduce the costs from foreclosure by, in effect, giving the homeowner the option to force a renegotiation on the owner or owners of the loan. This option takes the form of what we call a prepackaged Chapter 13 bankruptcy, in which the mortgage is automatically readjusted in line with the decline of housing prices in the homeowner’s ZIP code. The homeowner ends up with positive equity in his house, so that he will either maintain the house or sell it outside foreclosure, and the creditor ends up with a claim of greater value than the foreclosure price of the house. Because both parties are made better off, the cost of credit should not increase in the long run; and taxpayers do not have to subsidize the scheme. The plan is premised on the assumption that widespread negative equity mortgages, as a consequence of the popping of the housing bubble,8 are the chief cause of the crisis, rather than loss of income caused by the recession, which the plan does not address.
Click here to read the remaining of the paper.
1 Mortgage Bankers Association, Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey, December 5, 2008, http://www.mbaa.org/NewsandMedia/PressCenter/66626.htm.
2 “For properties sold at foreclosure auctions in 2006, first resales that occurred that same year brought 63% of county-estimated market values. First resales that occurred in 2007 brought only 44% of estimated market values.” Josiah Madar, Vicki Been, and Amy Armstrong, Transforming Foreclosed Properties Into Community Assets New York University Furman Center for Real Estate and Urban Policy (2008).
3 Guiso, L, P. Sapeinza, and L. Zingales, Moral and Social Constraints to Strategic Default on Mortgages, University of Chicago Working Paper (2009).
4 Alan M. White, Deleveraging the American Homeowner: The Failure of 2008 Voluntary Mortgage Contract Modifications (2009), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1325534, reports that the losses in foreclosure of forced lien mortgages were 55 percent. Assuming an initial down payment of 5 percent and a decline in house prices of 30 percent, the deadweight loss in default is around 40 percent.
5 Mortgage Bankers Association, supra.
6 In some contracts, MBS holders can approve a loan renegotiation by vote, for example, 60 percent; however, this process appears to be cumbersome.
7 Tomasz Piskorski, Amit Seru, and Vikrant Vig, Securitization and Distressed Loan Renegotiation: Evidence from the Subprime Mortgage Crisis, Chicago Booth School of Business Research Paper No. 09-02 (2008), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1321646.
8 See Shane M. Sherlund, The Past, Present, and Future of Subprime Mortgages, Finance and Economics Discussion Series 2008-63 (Federal Reserve Board, 2008); Elmendorf, supra.