In a remarkable editorial, the New York Times informs us that Senate Republicans are blocking the economic recovery by impeding legislation that would allow bankruptcy judges to modify the terms of troubled mortgages.
Let’s begin by examining the Times’s unquestioned assumptions. The biggest, ugliest one is that we must prevent mortgage foreclosures at all costs. This error is very important to understand, because it’s shared by Sheila Bair at the FDIC, Barney Frank at the House Finance Committee, and nearly everyone else who’s engaged in making policy.
The high incidence of distress in home mortgages is happening for a very good reason: housing is still overvalued, both in an absolute sense, and relative to household income. We simply built too many houses during the bubble, and that oversupply needs to be worked off over time. And now that equity values have stopped rising every month, people have nothing but their incomes to fund their mortgage liabilities and, on average, that’s not enough.
Therefore, to say that we must apply policy to prevent foreclosures is to deny economic reality. The effect of government’s multifarious efforts to keep people in their homes is to prevent the housing bubble from fully deflating, which must happen for us to start directing economic resources rationally again and get a recovery under way.
And yes, I’m well aware of the argument that an endpoint housing deflation can permanently equilibrate the market at far lower levels. Guess what? That’s a pretty accurate description of a low-leverage, expensive-capital world. And how is that any different from the real private sector economy we have today? To suppose that policymakers can counteract this is to believe you can stop water flowing downhill: in reality, you can only slow it down, and you’ll get awful wet in the process.
Now let’s look at the Times’s point about loan modifications in bankruptcy. Today, lenders have very little incentive to modify troubled mortgages by reducing the principal amount owed on the house. But from the borrower’s viewpoint, that’s the only modification that makes any sense. Borrowers are in distress mostly because their mortgages are too big for their incomes, and their home values have declined below the point at which they can sell out without taking a crippling loss.
But if a lender reduces the principal amount of a loan, he’s literally transferring economic value to the borrower without compensation. No one does that voluntarily, and the counterargument (that borrowers are likely to stay current on reduced-principle loans) turns out to be largely untrue anyway.
What’s the proposed solution, encoded in pending legislation and championed by the Times? Change the bankruptcy law and allow judges to force lenders to involuntarily make principal-amount reductions.
What’s wrong with that? For one thing, it’s unconstitutional. A mortgage is a secured asset. In default, the lender has the right to seize the house. That security is what makes it possible to borrow money to buy a house at a single-digit interest rate, as opposed to the double-digit rates that are typical for unsecured debt, like credit card balances.
So if you eliminate the ability of a lender to recover his security in a default, you’re taking away his property. Facially, that violates the Fifth Amendment. But forget about that (if you can).
If we change the bankruptcy law to allow judges to reduce mortgage principal amounts, then we’ll de facto be converting every mortgage in America (all $12 trillion worth of them) from a secured to an unsecured credit. That means future mortgages will be far less affordable unless taxpayers subsidize them, just as we currently subsidize student loans.
And what about the effect on existing mortgages? if you accounted honestly for the effect of involuntary principal reductions, it would sharply drop the value of every mortgage asset (and every bank balance sheet) in America, and in a good part of the rest of the world (which lent to us during the bubble) too.
Something tells me that Tim Geithner isn’t going to be adding a factor to account for that in his bank stress tests.