Preventing foreclosures won’t fix America’s housing mess. Encouraging banks to write down mortgages might

America's property market

Oct 21st 2010 | from PRINT EDITION

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AMERICA’S mortgage lenders are again at the centre of a scandal. This time the cause is not the recklessness of their lending, but the sloppiness with which they are dealing with the resulting defaults. Recent revelations suggest that many lenders rode roughshod over legal niceties to push delinquent borrowers out of their homes. Although banks claim the irregularities are minor, “Foreclosuregate” risks becoming a quagmire. Prosecutors across the country have launched investigations. Many politicians (though to his credit not Barack Obama) have called for a moratorium on repossessions.

None of this will help America’s moribund housing market. Tying the process of repossession in yet more knots will make it harder for the market to clear and for house prices to find a floor. Ideally, politicians ought to speed up foreclosure, which in some states can take up to two years. Moving somebody out of his home quickly may sound heartless; but stretching the process out is a bad idea. Would you bother to look after a property you were due to be expelled from?

Unfortunately, few politicians are likely to champion faster repossessions. And even if they were to, the scale of America’s mortgage mess would still be daunting. Around 2.5m homes are in the process of repossession, and 11m (or nearly 25% of all homes with mortgages) are “underwater”: borrowers owe more on their mortgage than their houses are worth. Since it is hard for such people to move home, this not only causes misery, but also clogs up America’s labour market.

• Economics focus: Drowning or waivingOct 21st 2010

• Barack Obama
• United States

Both lenders and the overall economy would be better off if more delinquent mortgages were restructured rather than foreclosed. The Obama administration, like George Bush’s team before it, has tried schemes to encourage lenders to keep people in their homes by reducing their monthly mortgage payments. But these have not worked well, mainly because reducing payments does little to prevent default when houses are worth a lot less than the outstanding debt.

A better route would be to reduce the mortgage principal, giving borrowers a bigger incentive to pay their debt. Even though they know this would probably mean they would one day get more money back, banks dislike this. If you let one person off paying what he owes, then surely his neighbour will want the same? Also, many homes have several claims or “liens” on them, which complicate any debt reduction. And lenders fear lawsuits from mortgage bondholders if they start writing down loan values. These are reasonable worries. How might government encourage a better outcome?

One extreme is to bribe banks into action with big subsidies: but that would require a lot more public money which voters are not inclined to provide. The other is to force the banks’ hand, for instance, by changing the bankruptcy code to allow judges to restructure mortgages in the same way as other loans. It might indeed make sense to change the law for future mortgages, but rewriting loan terms retrospectively tramples on existing contracts and property rights, and should not be done lightly (see article).

A matter of principal

So the best bet is a series of more moderate options to nudge lenders in the right direction. Regulators should force banks to write down the value of second liens, which are often held at vastly inflated values on their balance-sheets. Existing subsidies for preventing foreclosure should be redirected towards reducing principal. Congress could shield banks from lawsuits that arise from a mortgage reduction, and offer favourable tax treatment to “shared appreciation” mortgages, where lenders share in the gains if houses subsequently rise in value.

Even these changes would be politically difficult. But, paradoxically, Foreclosuregate may actually help. By shining a spotlight on the scale of the mortgage mess, it also opens an opportunity for a fresh start.