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The Role of Recourse in Foreclosures

posted by Adam Levitin

Martin Feldstein has been pushing a mortgage bailout proposal that has been getting some undeserved attention (see here and here, e.g.).  Feldstein gets  (here, and here) how central negative equity is to the economic crisis.  Homeowners with negative equity have a reduced incentive to stay in their home if the mortgage is burdensome.  Negative equity fuels foreclosures, which in turn force down housing prices, setting off a downward spiral. Feldstein is right to focus on negative equity as a key issue for housing market stabilization. The problem is in his solution--it is based on a few erroneous factual premises, all of which could have been discovered with very limited Google searches. 

Feldstein argues for the government to partially refinance mortgages with low-interest loans.  That’s not a unique idea, and the problems involved with having the government assume private mortgage debt (e.g., bail out lenders and socialize losses) are well-known. 

Feldstein adds a twist, though.  He recognizes the problem with socialized losses and tries to guard against that by insisting that the government refinanced part of the mortgage be “recourse”—that is the government could look not just to the house for satisfaction of its debts, but also to the homeowner’s other assets.  (Feldstein would also make this debt non-dischargeable in bankruptcy, something which rightly gives Ian Ayres pause.)   

Feldstein believes that having “non-recourse” mortgages is a major factor encouraging homeowners to walk away from underwater properties.  He writes:

The “no recourse” mortgage is virtually unique to the United States. That’s why falling house prices in Europe do not trigger defaults, since the creditors’ potential to go beyond the house to other assets or to a portion of payroll earnings is enough to deter defaults. Officials and investors in other countries are amazed to learn that U.S. mortgages are no recourse loans. It is indeed surprising that this rule in the U.S. applies to home mortgages but not to any other type of loan.

Feldstein's proposal is astoundingly uninformed.  Even the most cursory glimpse at the European mortgage market shows that Feldstein has not done the type of research necessary to make an intelligent international comparison, much less reach his specific conclusions.  (Just to talk about a “European” mortgage market is problematic—real property law remains intensely local.) 

What scares me is that this proposal has gotten a fair amount of attention (and not just from other economists, but from policymakers too, although there are no weblinks I can post) simply because Feldstein’s name is attached to it.   When celebrity economists jump into policy debates without having done their homework it gunks up the policy discussion and distracts policymakers from the well-informed and thoughtful proposals (of which there are several around).

So what specific errors have me so hot under the collar about Feldstein’s proposal?

First, Feldstein doesn’t know from Adam whether US mortgage lending is recourse or not.  It is very hard to generalize about US foreclosure law.  It varies state by state has often Byzantine complexities.  (Why we do not have uniform property law in an age of national lending is an interesting question.)  Generally speaking, however, most mortgage loans in the US are recourse.  There are exceptions, such as purchase money mortgages in California and all 1-4 family residences in North Dakota, and various states limiting deficiencies if a creditor proceeds through a non-judicial foreclosure.  But in most states a deficiency judgment is possible. 

Second, Feldstein doesn’t seem to get the real value of recourse.  The fact that a loan is called “recourse” doesn’t actually mean that it will be recourse in practice.  It’s costly and time consuming to persue deficiency judgments on foreclosures.  State property exemption laws often protect debtors’ assets, and wage garnishment requires a debtor with a job and can take a long time given federal and state garnishment limitations.  And the debtor can always file for bankruptcy and get rid of the unsecured deficiency debt.  As a financial matter, recourse doesn’t have a whole lot of value, and lenders often do not pursue deficiency judgments. 

Instead, the primary value of recourse lending is as a threat.  But here’s the thing.  Most homeowners, if asked, would assume that their mortgage is recourse, regardless of whether it is or not.  Thus whatever in terrorem effect exists from recourse is already in place, regardless of whether or not it is legally enforceable.  (And the really sophisticated borrowers know that even if a loan is recourse, they can probably arrange a short sale in which the deficiency is forgiven.)  There really is no extra “umph” to his proposal from making the loans non-recourse. 

Third, Feldstein points to Europe and says that Europe does not have a negative equity problem because loans there are recourse.  This statement is wrong in three ways:

(1) Feldstein has no idea what “European” mortgage foreclosure law actually is (and neither do I) and whether deficiencies are actually pursued and what assets are available to satisfy them.  Feldstein hasn't even taken the first step of determing what the law is on paper, much less dug into what it is in practice.  Without knowing this, there’s simply no way to make the comparison responsibly. 

(2) The obvious explanation for why those European countries that do not have negative equity problems have avoided them has nothing to do with recourse.  It has to do with Europe’s generally much higher down-payment requirements that result in VERY low loan-to-value ratios that create a large equity cushion for lenders.  For example, Denmark and Italy limits LTV to 80% by law and LTV is typically 50% in those countries.  Poland is 70-80%.  The average LTV on UK loans originated in 2005 was 78%.  In Greece it must be less than 75%.  The standard in Germany is 73%. In Spain, LTV is 66.5% on average.  And in France, LTVs are typically 16%!!! 

(This data is from the European Mortgage Federation.  It’s not as precise as I would like, but it makes the point pretty starkly nonetheless.)  There are costs to requiring high LTV rates--first-time homebuyers are often older in Europe. 

(3) In those countries, like the UK, where some lenders have abandoned the basic rule of asset-based lending—ensuring a large equity cushion—there are negative equity problems. (See here and here, for UK negative equity problem.)  Recourse won’t do the trick unless it is part of a shift from asset-based to cashflow-based lending.   

I'm glad that Feldstein is thinking about the negative equity problem, but recourse is a red herring. 

Comments

One of the interesting things of the more-or-less non-recourse purchase money loan is that this law (at least in California) is said to have been passed to discipline (by loss of money on lent on over-valued real estate) the lenders who in earlier days were thought to have a propensity to lend more than property was worth to unknowing buyers.

Sounds familiar.

Hasn't worked too well this time around, what with securitization etc., but, it is better than nothing. A lot of my clients are wisely walking away from wacky loans.

Nice... It's not enough for a servicer to be able to STEAL the property securing a mortgage but then they could also go after homeowner's vehicle, 401-K, children's college funds, etc...

Oh, I'm sorry.. I just realized that I stopped reading after the fourth graph... My apologies, Professor, I'm sure you made several excellent points - my head just hurts too much after banging it against the wall after reading what I have so far...

I wonder if the good Mr. Feldstein caught the recent class action that was filed in MA. "The suit filed in Suffolk Superior Court alleges that since 2004 GMAC Mortgage, Deutsche Bank National Trust, Harmon Law Offices and Ablitt Law Offices foreclosed on properties despite the fact that they do not own or were not assigned the mortgages."

Archived Boston Herald story:
http://news.bostonherald.com/business/general/view/2008_11_21_Lawyer_to_lenders:_Prove_you_own_mortgages/srvc=home&position=alsoOffices

Full piece:
http://www.websitetoolbox.com/tool/post/ssgoldstar/vpost?id=3135546

But, by all means, let's initiate "recourse" mortgages as homeowners weren't being screwed enough by juiced appraisals, blatantly fraudulent loan app paperwork, and servicers manufacturing defaults, piling on bogus fees and just plain stealing homes that they allegedly had zero right to foreclose on in the first place...

I'm sorry - that sounded a tad bitter didn't it... Pardon me while I go bang my head against the wall some more...

One of the reasons for the current negative equity situation in the United Kingdom (alongside a growing acceptance in the last few years of offering higher LTV ratio mortgages thanks to banks' ability to collateralise and dump them)has been the prevalence of fraudulent behaviour by developers, with the complicity of homeowners, to disguise higher LTV rates.

Developers have been offering a "discount" to the prospective homeowner, while giving a bogus higher value of the property to the mortgage lender. This has led to real LTV ratios of 100% or more, while the lenders, using the inflated value of the property, calculate themselves to have an equity cushion which is nonexistent. This has happened at a time when traditional cashflow-based restrictions were being relaxed, with mortgages offered in some cases for five times the applicant's annual income.

Many of these deals were done on huge developments of two-bedroom flats which were built not to be lived in, but to be sold to first-time landlords, with no real expectation of finding any tenants. Now many of them are lying empty, and with a majority of properties owned by inexperienced absentee landlords (many tempted to walk away on the basis that recourse is almost never enforced) or already foreclosed, there is little hope of preventing them falling into decay.

The legal and de facto non-recourse nature of many U.S. mortgages is a problem exacerbating the foreclosure crisis. It does allow people to walk away from their home loan obligations with less chance of continuing collection efforts than defaulting on a credit card debt. And that fact is fueling, to some extent, the foreclosure/economic crisis we are now facing.

But.....

Only a small part of the "non-recourse" problem is directly related to state laws that don't allow deficiency claim collection. While there are several states where a deficiency judgment is not permitted, there are many more that do allow deficiency judgments if the lender elects to take a mortgage, instead of a deed of trust, and/or, if the lender goes through the extra steps necessary to obtain a deficiency judgment.

However, to grossly generalize, most lenders opt to either take deeds of trust, that don't permit a deficiency judgment, instead of mortgages that do, because non-judicial foreclosure, without obtaining a deficiency judgment, is a quicker way to get the property back. The decision on how the loan documents would be set up, in terms of balancing speed versus the possibility of a deficiency judgment, were, in most instances, made prior to the current economic climate, and the lenders chose to go for speed, rather than the ability to get a judgment against the defaulting borrower.

There is also a local foreclosure culture - a "way things are done" - that varies from state to state. In many states, the procedures to obtain a deficiency judgment are used only in rare circumstances, even if they are legally available. Word of how things are actually done filters out into the community of defaulting borrowers, and they make economic decisions on that basis.

Even today, the ability to chase defaulting borrowers is of dubious value. Mortgage lenders could not take, for example, 401(K)s, because they are protected from creditors by federal law. State exemption laws protect other property from execution and sale. Looking at the practices of credit card collectors (and grossly generalizing), most of them rely on 1) telephone harassment; and, 2) wage garnishment; to try to collect debts, not taking property and selling it.

Even if mortgage companies did, to the extent permitted by local law, obtain mortgages and go through the procedures required to obtain a judgment, many states have specific, very short statutes of limitations for the collection of mortgage deficiencies. In states with such limitations, obtaining a judgment isn't going to do the mortgage company much good if they only have two years to collect on it.

If state legislators want to debate doing away with non-judicial foreclosures in deed of trust/combined deed of trust-mortgage states, and having deficiency judgments on real estate be a customary part of the foreclosure process on new mortgages - have at it. The trade off for borrowers is a legal process that affords them much more in the way of due process - and time - than non-judicial foreclosures on deeds of trust or mortgages with power of sale clauses.

On the other hand, making borrowers choose between foreclosure and a non-dischargeable recourse bailout loan, seems a bizarre response to a problem created primarily by choices that were made by mortgage lenders, and continue to be made by mortgage lenders, that the ability to obtain a deficiency judgment on residential real estate is not that important to them. Speeding up their ability to obtain possession of the always-appreciating real estate asset was of primary concern to mortgage lenders.

That business mistake by mortgage lenders - if it was in fact a mistake - should not put vulnerable borrowers into a position of having make a choice between losing their family home or taking on a loan that is more in the legal nature of a student loan than a mortgage. There were strong policy reasons (same as bankruptcy - a fresh start) behind the laws that limited the collectability of mortgage deficiencies, that made sense before the rush of investment banks to create sub-prime MBS's ruined the housing market and our national economy.

The best answer remains the same one that the Mortgage Bankers Association has been fighting tooth and nail - allow loan modifications on debtors primary residences in Chapter 13. Foreclosure moratoriums stop foreclosures on houses where borrowers don't want to try to save their ownership rights. Voluntary loss mitigation was a joke until recently, and has led us where we are today, with a glut of houses on the market. Government loan programs cost taxpayer money, and are hit or miss in terms of eligibility. And Feldstein's idea is just goofy.

I am seeing the Developer problem here in Texas as well. I see them doing these "owner" financed deals and then farming off these kooky loans to bigger Mortgage and Servicing Cos. I hadn't put 2 and 2 together until Michael just said "Developers have been offering a "discount" to the prospective homeowner, while giving a bogus higher value of the property to the mortgage lender". I was wondering why these bigger Mortgage Cos were buying these seemingly unworkable loans.

Making deficiency debt on mortgages non-dischargeable in Bankruptcy would in my mind discourage people from ever seeking a mortgage in the first place. If that Mortgage deficiencies were made non-dischargeable, rents for rental property will go up because renting would be the safer option and there would be more people renting than buying. Who can predict the future? It would be a debtors’ prison for sure.

Failure to appreciate how U.S. mortgage law works seems to be a problem endemic to economists (forgive the over-generalization). I noted a similar problem published in The Economist earlier in the year: http://ucclaw.blogspot.com/2008/10/comparative-mortgage-confusion.html What's up with these people?

I think the original post's criticism of Feldman's proposal is right on. I would add, I don't think there is any evidence to support the contention recourse loans perform better than non-recourse loans. One place to look for such evidence is loans which have subordinate home equity lines. Those lines are invariably recourse and in theory should perform better, but in fact they don't. The reality is that borrowers tend to pay uintil they can't, and at that point it doesn't matter if the loan is recourse or not, because there is nothing left to go after. I've written about why that's the case in the income property context at the link below, and I think the logic is the same for home loans.

I just found this blog, great work!

http://residentialpropertyanalytics.blogspot.com/search/label/Recourse

Agree that the Prof Feldstein's recourse / nonrecourse analysis is so wrong to be useless. Don't actually agree that negative equity is the problem you think it is, although it is both a blessing and a curse problem in the sense that it eliminates the ability to use home equity as a source of consumer credit. Having been a homeowner with negative equity throughout the 90s, based on a late 80s home purchase, I find that negative equity REDUCES a primary residenc's owner's desire to change the status quo by e.g., walking out and turning the home over, crystallizing the loss and requiring one to deal with the deficiency claims. I know of no empirical evidence that it incentivizes one to default on a primary residence. Obviously those defaults happen, but they happen for cash flow reasons not for negative equity per se.

a few comments about the uk market, which is probably the most comparable in europe to the usa:

- there is a strong culture, particularly among the more traditional mortgage lenders, not to foreclose. some of the old regional building societies pride themselves on never having foreclosed in their history. the preference of these lenders is always to rework the terms of the debt, as the lender usually does better this way in the long term.

- in the recent housing boom, a sub-sector of lenders specialised in the uk equivalent of sub-prime lending. a few of these were old-fashioned lenders, like northern rock, which set up its own master spv structure for repackaging loans into mbs. nr was the first uk bank to get nationalised in this crisis. a lot of the riskiest lending (in terms of borrower creditworthiness) however was being done by entirely new companies that specialised in dredging the bottom of the credit barrel.

- the counsel of mortgage lenders just published its 2009 outlook, in which it forecasts 75,000 foreclosures for next year. this is very high by uk standards, but low compared to the 250,000 current negative equity number. most of these foreclosures relate to the new niche lenders and not the mainstream lenders.

- although mainstream lenders were more conservative in terms of who they lent too, they did loosen standards in terms of ltv in the hubris at the height of the house price boom. 90-100% was quite common (albeit only for the better credits). 125% loans were available from the most aggressive lenders.

see robert peston's blog at the bbc, which is by far the best source for all information about what is happening in the uk financial markets during this crisis:

http://www.bbc.co.uk/blogs/thereporters/robertpeston/

I don't know what the situation is in the rest of the EU, but in the UK the standard (admittedly informal) advice of the debt charities tends to be to negotiate a very small settlement (i.e. £500 - £1000 for a £100k shortfall) quickly after reposession, OR to go bankrupt if they refuse the settlement.

Bankruptcy in the Uk generally doesn't produce any surplus to creditors, since the OR fees are high, and most investment assets (pensions etc) are protected. Therefore, creditors are willing to accept very significant settlements.

So, recourse isn't really a major factor in whether people walk away or are reposessed. Generally, the main deterrant is the fact your credit record is destroyed in the process of getting reposessed.

"Most homeowners, if asked, would assume that their mortgage is recourse."

I disagree. I asked a few co-workers whether they think their mortgage is recourse. They all said no.

This paper by Bank for International Settlement specifically identified non-recourse (by law or by practice) as one of the reasons the loan default problem is more severe in the United States.

The housing meltdown: Why did it happen in the United States?
http://www.bis.org/publ/work259.pdf?noframes=1

I agree with those who note that the recourse nature of a home mortgage usually has little to do with default. When it comes to homes, for the most part, I think its all about cash flow. When a family walks away from a home, they also leave a neighborhood, the local schools, etc. and incur the costs of relocation. These are costs that most families don't shoulder lightly -- and few take on just to "walk away" from a house that is underwater.

I agree with lmclark. For people to walk away from a home there has to be more to it than being upside down. I think being upside down is the last straw.

I agree that Feldstein is barking up the wrong tree. It seems to me that it is the entire incentive structure that is deeply flawed. The mortgage originators collect their fees, and they are under no incentive to verify consumer information. The bundlers and securitizers collect their fees. By the time we are looking at the markets in MBSs and start worrying about the quality of the loans, there is literally no recourse because the thing has been through so many hands, with each hand simply maximizing their own return, and shoving it off to the next.

It reminds me of assembly workers who deliberately put defects into the products. These defects are then caught by quality control workers who get a bonus for every defect they find. The quality control workers then share the bonuses with the assembly workers. Happens all the time.

MANDAB--An Economic Proposal by Eric Strong

Why don't we insist any financial institution who takes government "bail-out" money do the following: If they take deed to property by foreclosure, they have to have an absolute auction, with no reserve, within fifteen days of taking title to that property. We can call it "mandatory absolute" or MANDAB. MANDAB will be opposed because the companies will allege they are going to get too little for the properties, but here is how it can help the larger economy: 1.) The companies will be more motivated to do "work-outs" or refinances of struggling borrowers, and 2.) If they do foreclose, the property is going to be sold quickly and the market keeps moving.

Now, it seems like there are bank-owned properties everywhere that just sit. The banks/lenders/servicers/etc. who own them after foreclosure are glacially slow and delusional about their low value so they just sit and the real estate market has trouble coming back to life. MANDAB could help the economy from two directions. More borrowers getting helped, and foreclosed properties getting into productive hands more quickly.

I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.


Deborah

http://termlifeinsurance2.com

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