12 August 2009

Betting the Farm

Economists and financial professionals view the right to encumber property with loans not related to acquiring the property as ordinary and unexceptional. To them, all property is just another form of money, and money is fungible.

Lots of consumer spending prior to the financial crisis was financed with home equity loans, and a great many small businesses used home equity as collateral for business loans. In many of these cases, selling the home to get the cash out, and buying a less expensive home would have been a viable alternative. But, selling a home disrupts your life, so there is a tendency to favor borrowing against it instead.

There are a couple of problems with using asset equity, and in particular, property that people use as consumers, rather than holding for investment purposes, as collateral for loans unrelated to the purchase. Indeed, with a few exceptions, it is illegal to take household goods as collateral for non-purchase money loans.

Valuation Issues

One set of problems isn't specific to homes and household goods.

A sale of property for cash is the most definitive and final determination of a property's value that is possible. The loan on that property has a 100% chance of being paid off to the extent of those proceeds, and the cash left over is cash that the seller has essentially zero risk of losing.

If consumer purchases or a business are financed by selling property and using cash proceeds from the sale, no lender or borrower faces any risk that there will be a default that will require property used as collateral to be foreclosed upon, and possibly even not satisfy the entire amount of the debt.

Any loan intended to be fully or primarily secured by collateral, in contrast, relies instead on an appraiser's estimate of what the property is currently worth, and a lender's estimate of expected changes in the value of that collateral over time. Appraisals, however, are not guarantees (a third party guarantee that the collateral would be sufficient to pay the loan would be called a loan guarantee, a mortgage insurance or a credit default swap, and of course, is worth no more than the counterparty that provides the promise).

An appraiser generally does not promise that it will be possible to sell property for the appraised price if the collateral must be sold because the borrower doesn't pay a loan as agreed. Indeed, an appraiser does not even promise that it will be possible to sell property for the appraised price on the date of the sale. Also, almost nobody conducts appraisals calculated to predict the likelihood that an asset will ever be worth less than the balance due on a loan if installments are paid as agreed, and the magnitude of any predicted shortfall, even though that is what the lender really wants to know in most cases.

Yet, lenders routinely rely on appraisals to confirm that their risk of loss is low because the collateral is worth more than the loan at the time the loan is made by the lender.

Generally speaking, the less equity there is after considering all loans that a piece of property is collateral for, the more important it is that an appraisal be accurate. The safety than an owner's equity cushion provides also depends upon the state of the real estate market. If the real estate market is near a bottom or just starting to head up, as it probably is now in many places, a big equity cushion is less important. If the real estate market has experienced sustained rapid price increases (i.e. if there are indicatations that a housing bubble is underway), then only a big equity cushion will protect lenders from the risk of loss.

Fixed term mortgages manage uncertainty about the future that appraisals don't provide, by front loading the lender's risk.

Inflation, which is the historical norm in the American economy, generally causes the nominal of the collateral to increase over time, even if its inflation adjusted value is unchanged. The combined miracles of the law of averages and compound interest, mean that inflationary asset price increases are greatest and most certain to have occurred towards the end of the loan's term.

The amortization schedule of the loan, even with a thirty year term, causes the nominal amount of the loan to decrease over time, and to decrease especially rapidly near the end of the loan term.

Meanwhile, over time, there is an increasingly likelihood that the property will be sold and the loan paid off because the owner's needs change and the owner sells that property to buy a new one increase over time, and borrower's that continue to make timely payments over time, on average, see their ability to pay increase both in real terms and due to inflation.

Of course, not all collateral tends to increase in value overtime. Business property and consumer goods tend to depreciate, rather than increasing in value. So, loans against this kind of collateral typically have much shorter terms.

The bottom line is that spending and investment financed with equity in property converted to cash with loans, involve higher systemic risk to the economy than spending and investment financed from equity in property converted to cash through sales. Moreover, the systemic risk avoided is one that lenders have a history of being lax about quantifying.

Behavioural Economics Considerations

The other problem with borrowing against equity, which is particular to homes, is that we are not "economically rational" actors.

Selling a home at a profit, in order to cash out its equity for other purposes, is far less traumatic, does far less harm to the commmunity, and requires far less intervention from the state, than foreclosing on someone's home. It also leaves the home's seller with little or no risk of suffering impaired credit, or of failing to meet contractual obligations.

Involuntarily losing your home due to an inability to make payments, on a strict liability basis without regard to whether the inability to pay the loan is your fault, is a crisis for the household losing a home, and can spill over into being a crisis for society at large. The involuntary loss of a home also means that some lender probably was harmed in the transaction, and that the home owner's credit has been deeply damaged. Modern credit reporting has kept shame and reputation alive as important factors in our economy.

The intangible harms associated with foreclosure are mitigated to some extent in purchase money transactions, where the household wouldn't have had a home in the first place if the home hadn't been available as collateral for the purchase. Before subprime loans, option ARM mortgages, "liar loans" and loans with nearly no downpayments or principal payments, and the like appeared on the market place, the likelihood that a purchase money mortgage (given to someone who actually needs one to buy a home) would ever go into default was extremely low, so the upside of allowing a household to own a home greatly exceeded the risk that a home foreclosure would inflict intangible harms on that household and the community they lived in.

The decisions that led us to where we are now didn't have such happy results. In the second quarter of 2009, 64% of home sales involved distressed sales, either by banks, or in short sales by households facing impending foreclosure.

One of the reasons that some lenders make loans for 125% of the value of a property, is that they know that the prospect of potentially losing a home will often make a borrower willing to pay more than the property is worth in the marketplace to keep it (the possibility that the home will increase in value before a default is another). The same psychology helps explain why lenders have lobbied so far to prevent "cramdowns" in bankruptcy for home loans, while permitting them for residential real estate (in a cramdown, the bankrupt is allowed to keep property after paying for the fair market value of the collateral, even if this is less than the face value of the loan).

Personal attachment to homes also encourages people to try to make loans long after the value of the home has irretrievably dipped below the the fair market value of the property. More than half of repossessed homes are neglected and abused by financially stressed households with no hope of keeping them or repaying their debt to the bank to the point that the homes are not in marketable condition when repossessed. It also isn't uncommon for households facing foreclosure to continue to live there until the multi-month process is complete increasing the size of their debt in the process. Owners of property with a more detached, primarily financial interest in it, in contrast, tend to give up sooner, leaving foreclosing lenders with property that is in better condition and has accured fewer interest charges, thus producing smaller losses for lenders.

Home equity loans also increase default risks on purchase money loans. The more debt someone carries, the more likely that they are to default on their loan secured by real estate. When a second loan on a home goes into default, the first loan is very likely to be neglected as well. And, after a housing bubble collapses, the likelihood that default will produce a loss for a first loan lender is much greater than in ordinary times, so the lender really does need to worry about the risk of default.

Current Legislation

Nothing is new under the sun and there were legislative responses that are aware of the issues particular to home equity loans on the books already. The disallowance of cramdowns on home mortgages in bankruptcy is one such law.

Most states require a multi-month process to give a homeowner every opportunity to salavage the property, in recognition of the intangible interest of a home owner in the property. A few states (Texas, for example) place significant limits on non-purchase money home equity lending in the first place. Almost all states limit the ability of creditors who did not take collateral in the first place to enforce judgment liens against home equity to some extent (in Florida, Texas and couple of other states this homestead exemption shield all equity in the vast majority of homes). The maximum size of a home equity loan that is tax deductible is also smaller than the maximum size of a first mortgage that is tax deductible.

Of course, the "natural rules" of borrowing and market sales of real estate invite subversion of any outright ban on home equity lending. An outright ban would simply create a gray market of sham transactions. Due on sale clauses already encourage a small but persistent stream of owner financed property sales disguised as property rentals. But, there might be benefits to laws that discourage home equity lending, and thus, indirectly, favor sales when owners want to cover home equity to cash, over loans.

Simply put, freer access to secured credit with home equity as collateral, is not necessarily better for the economy, when urgent needs for cash in the market can be dealt with through voluntary sales of property with equity instead.


While mortgages are almost always declared due on sale, even if highly oversecured, they are rarely declared due if the homeowner secures a second mortgage. Lenders could, in theory, make a bar on second mortgages a covenant in their loans. (Second mortgage holders could be denied an enforceable mortgage lien and treated as mere unsecured creditors subject to the homestead exemption, in cases where such a covenant is of record and consent was not obtaned from the first loan holder.) But, either due to regulatory limitations or industry custom, they don't. Encouraging such covenants would reduce mortgage default risks, and hence make our economy more robust.

An end to the tax deduction for mortgage interest on new home equity loans would be another good start.

Laws that would make permanent the deduction for private mortgage insurance would also help. Private mortgage insurance is a backstop against harm to lenders that didn't suffer from counterparty risk problems nearly as severe as those seen in credit default swamp market. This is true, in part, because private mortgage insurers who are regulated as insurance companies, need to maintain reserves in amounts determined by regulators to cover their losses, and in part, because of the way the insurers evaluate risk which differs from the way that securitized second loan security buyers evaluate risk. A shift to private mortage insurance from second mortgages would encourage lenders to deny more high risk loans that pose the greatest risk of harm to borrowers, lenders, the community and the economy in hard economic times.

Denial of foreclosure rights to lenders whose loans exceed the appraised value of a home at closing; requiring the secured and unsecured portions of the loan to be segregated from the start (a distinction already made for tax purposes), might be another.

Allowing cramdowns in bankruptcy for home mortgages would encourage lenders to be more cautious about making low down payment loans, where a cramdown loss is a realistic possibility.

Also, for the same reasons that a voluntary cash out with a complete sale up front is more desirable than an involuntary foreclosure, there might be good reason to legally encourage short sales over foreclosures. Easier access to short sales also improve geographic mobility in the job market during what tend on average to be hard economic times.

For example, perhaps there ought to be, in consumer transactions, at least, a requirement that permission to make a short sale of a property not be unreasonably denied. The general principle that breach of contract damages must be mitigated supports this idea. This could be enforced with a market based/contract damage mitigation remedy.

The lender could be required to bid at least the bona fide short sale amount in a foreclosure sale, regardless of any appraisals to the contrary, and would be required to waive all interest on the tendered short sale amount, all carrying costs and all legal fees accruing after the soonest date that the tendered short sale could close (perhaps a rough justice thirty days after the offer is received if no sooner date is established). Short sale amounts might also be computed before customary real estate agent commissions for this purpose, because a real estate agent commission is not normally allowed as a cost of sale in a foreclosure sale.

This kind of remedy would retain the deficiency judgment incentive not to simply wait out the foreclosure period and walk away that exists in states like California, and would give many foreclosed upon homeowners stronger incentives to find buyers at decent prices themselves. The smaller deficiency judgments that would result would also be more likely to be paid, and lenders encouraged by these incentives would be less likely to act in a way that is economically irrational. The cost of these rules to lenders who are acting in an economically rational way, however, would be negligible.

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