Preventing Mortgages From Going Underwater (Second Article on Weaknesses of the Standard Mortgage)

December 12, 2016

One weakness of the standard mortgage in the US, discussed last week, is the extreme rigidity of the payment obligation, which makes it very difficult to manage the repayment process efficiently. In last week’s article, I suggested that this problem could be fixed best by defining the borrower’s contractual obligation in terms of a maximum loan balance that would decline month by month, rather than a minimum payment. The second weakness, discussed below, is that the borrower must assume a risk that her equity in the property will decline due to circumstances beyond her control. This happened to most homeowners during 2006-2011.

The purchase of a house is an investment, and for most purchasers it is a highly leveraged investment. While a consumer who purchases securities can borrow only 50% of the value of the securities, when she buys a house she can borrow 80-97% of its value. High leverage means high risk. If you borrow 97% of the value of a house, it takes only a 3% decline in the value of the house to wipe out your equity.

Most of the time, highly-leveraged house purchases have worked out well for the purchasers, but during my lifetime there have been two episodes in which price declines wiped out enormous amounts of homeowner equity. These were 1929-35 and 2006-11. In both periods, the increases in mortgage defaults and foreclosures played a major role in depressing economic activity.

In their recent book House of Debt, Atif Mian and Amir Sufi show that reduced consumption by consumers who had lost equity in their homes was a major factor in prolonging the recent recession. To prevent that happening again, they propose that the existing standard mortgage be replaced by what they call the “ shared responsibility mortgage”, or SRM. The key feature of the SRM is that the mortgage loan balance is reduced when a home price index declines.

For example, if a home is purchased for $400,000 with a $360,000 loan and the price index declines 5%, the loan balance would be written down to $342,000, preserving most of the owner’s equity. The larger the loan, the larger the write-down. From the homeowner’s perspective, this would be a really nice feature. It fits very neatly into a loan contract where the borrower’s contractual obligation is defined in terms of a maximum loan balance rather than a minimum payment, The key issue is the offsetting benefit to investors that would make the instrument acceptable to them.

The procedure of changing the loan balance in response to a change in a house price index can’t be symmetrical, because house prices rise much more often and for longer periods than they decline. A mortgage subject to future increases in the balance would be unworkable, with many borrowers unable to get out of debt. Mian and Sufi suggest that the quid pro quo to investors could be a share of the appreciation on the house, but that would mean that most borrowers would pay a price for which, in their eyes, they received no benefit because prices did not decline. Shared appreciation is also messy to administer, raising all sorts of issues such as when the payment is due.

A simpler approach would retain balance reductions in response to all price index reductions, but price index increases would result in loan balance increases only for borrowers whose balances had previously declined in response to past house price declines. Further, the balance increases should be limited to prior balance decreases. Hence, in a normal state of the world when house prices are rising, balances would not be affected. When there is a recession-induced period of house price declines, balances would be written down, and when prices started up again, loan balances would be raised. but the increases would be limited to the previous declines.

The drawback to the investor is that price declines would be larger than the subsequent price increases because some borrowers would avoid the balance increases by refinancing, and some might even pay off their loan. On the other hand, the balance reductions would reduce the volume of recession-induced defaults, and lenders would be free to price the new approach based on their appraisals of the risk involved.

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