We Ask Why Not?
RGE Monitor, an economics intelligence piece led by New York University econ guru Nouriel Roubini, maps out the math of mortgage stop-loss modification. The piece is entitled “The Housing Crisis and Bankruptcy Reform: The Prepackaged Chapter 13 Approach.”
Since about 10% of the $10 trillion mortgages are currently delinquent or in the foreclosure process, 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.
What would become of the Stress Test if a bank adopts this approach? It’s certainly worth exploring. Rescue policy fatigue is setting in big time.
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Sounds like a classic co-ordination problem? Every bank has to assume that everyone else is going to foreclose, and so it is in its own interest to foreclose before others do, in order to avoid even more disastrous valuations later on. If 10% of all banks decide not to foreclose, and the other 90% foreclose, then the 10% will lose. If 90% chose not to foreclose, and 10% do, then the 10% will benefit greatly from higher recoveries. In the end, in classical game theoretical fashion, it pays, from the individual bank’s perspective, to foreclose.