Equity, Liquidity, and Bankruptcy
Earlier this week at Vox, economists from the University of Minnesota and the Fed posted the results of a study investigating the causes of subprime mortgage defaults. In particular, the researchers wanted to figure out whether such defaults were more often caused by liquidity constraints – a homeowner’s ability to pay – or by negative equity – when mortgage liability exceeds a home’s value, effectively increasing the equity of a homeowner who walks away from her house. They conclude that decreasing home prices and household illiquidity are about equally responsible for “the increasing propensity of borrowers to default”.
The authors flesh out the policy implications of their findings, writing:
Because we find empirical importance for both illiquidity and net equity as drivers of default, this suggests that effectively mitigating foreclosures would require either some combination of policies targeting each cause, or a single instrument that targets both. For example, loan modifications that merely increase payment affordability by extending loan lengths would not be very effective as a standalone measure, as they would leave borrowers’ equity positions unchanged. On the other hand, write-downs on loan principal amounts would address both causes simultaneously, with the reduction in loan size serving both to increase the borrower’s net equity as well as reduce monthly payments.
The findings point out the weaknesses of some of the current proposals to address the foreclosure crisis, from the $7,500 tax credit included in the House and Senate stimulus packages and efforts to force down interest rates, both of which aim to prop up home prices, to bank loan modifications that focus on making payments more affordable.
Mortgage modification in bankruptcy, on the other hand, seems a better fit for the study’s criteria for an effective means of addressing the foreclosure crisis. Through Chapter 13 “cramdowns”, bankruptcy judges would lower the principal and/or interest rates on foreclosed homes, which is not currently permitted. As Adam Levitin of Georgetown Law wrote in a paper published earlier this month:
Bankruptcy modification would also provide a solution for both of the distinct mortgage crises—negative equity and payment shock. Bankruptcy modification would help negative equity homeowners by eliminating their negative equity position (“cramdown”), which would reduce their incentive to abandon the property. Likewise, homeowners who are unable to afford their mortgage because of a rate reset, due to the expiration of a teaser rate or to the resetting of an adjustable rate mortgage or to the reamortization of an option-ARM could modify their loans to make monthly payments fixed and affordable...
Megan McArdle at The Atlantic, who has criticized cramdowns in bankruptcy, is concerned in part that such modification would incentivize bankruptcy:
If you allow bankruptcy judges to hand people loan modifications of 10% or more of face, you will get all the people who would have been foreclosed upon declaring bankruptcy, plus a lot more. So instead of writing down the value of, say, a million homes in foreclosure, you suddenly write down the value of three million in bankruptcy.
The availability of mortgage modification in bankruptcy would inevitably provide an incentive to neglect payments, provoke default and foreclosure (legislation currently before Congress would limit bankruptcy modification to foreclosed homes), and then seek out bankruptcy.
However, there are two reasons why incentivizing bankruptcy in this way would not engender the negative consequences Megan envisions. First, the pain involved with bankruptcy makes it a rather unattractive option. Second, it seems that the homeowners most likely to default “on purpose” – who aren’t already going to enter foreclosure because of liquidity constraints anyway – are the best candidates for modification, both for the individual homeowner and for the stability of the housing market. These best candidates are underwater homeowners without liquidity constraints.
The possibility of bankruptcy provides an incentive for an underwater homeowner not to simply walk away from her home in order to increase her equity position. Bankruptcy would restore the homeowner’s equity position (to zero), keep the homeowner in her home, and avoid the externalities associated with an abandoned property. The “extra” bankruptcies would, in fact, be beneficial. Finally, homeowners who proceed through bankruptcy in this way are presumably less likely to redefault because they were not liquidity constrained in the first place.
Of course, some homeowners who are able to pay their mortgage and who have positive, but declining equity might have an incentive to seek out bankruptcy. Further, interest rates might rise down the road (though Professor Levitin provides some evidence that lenders price based on foreclosure risk, not bankruptcy risk), contracting lending overall and in certain locations (and for certain borrowers). The first concern is outweighed by the effectiveness of confronting both liquidity and equity issues in bankruptcy; the second concern might lead us to rethink what we consider effective housing policy.