Thursday, March 06, 2008

Should lenders take haircuts to stave off default?

It is a tempting solution to the current problem: for those whose mortgage balance is greater than their house value, cram down the loan owed to the value of the house. This will presumably reduce the probability of default substantially, and losses will (largely) be borne by those who took on the lending risk. Ben Bernanke likes the idea, and he knows a lot more about financial crises than I.

But two serious problems stand out. First, future investors could respond by requiring higher spreads for mortgages. If these spreads get capitalized into values, the borrowers whose loans got crammed down could find themselves under water again, and the problem will remain.

Second, there is an issue of fairness. Consider two borrowers, one of whom has a 20 percent down payment, and the second of whom has a 5 percent down payment. If house prices decline by 10 percent, the second borrower gets debt forgiveness, while the first one doesn't. Perhaps the first casualty of financial crises is fairness, but as a policy matter, it is hard to ignore the problem.


Anonymous said...

Hard to escape the conclusion that our Fed Head can't think too far ahead or is too firmly influenced by Rep. Frank. Not a comforting conclusion either way.

Anonymous said...

"Second, there is an issue of fairness. Consider two borrowers..."

I note that the issue of fairness is limited to borrowers. No one seems to be concerned with fairness to savers.

Austin Kelly said...

I have to think the alleged impact on borrower rates from cramdowns, while not zero, is way overblown (for prime borrowers). Typically prime borrowers have cumulative foreclosure rates around 1% and loss given default around 30%. If cram downs doubled both figures (a really extreme upper bound) the effect would sum to less than 1 point upfront -30 bps for the doubled severity on the foreclosures that would have happened anyway, and 60 bps for the new foreclosures. Maybe 15 to 20 bps as an annual charge. Not my expectation, but the high side of the possibility. Not nearly enough to have a meaningful impact on things like homeownership rates. And presumably pretty much a wash from the average borrower's perspective - mortgage lenders will get less from bankrupt borrowers, but unsecured creditors would get more, and so would see rates on things like credit cards go down.

For subprime borrowers the effects could be much more dramatic, but since most would agree that we've seen way too much subprime lending of late, there are those who would see this as a feature, not a bug.