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Getting Rid of Nonrecourse Mortgages?

posted by Adam Levitin

It's interesting to look at some of the reader comments to the NY Times article about the rich being more likely to default on their mortgages.  A lot of them are aghast that a mortgage might not be full recourse--that one can walk away and have no personal liability.  What happened to one's word being their bond, honor, etc?  

Since the onset of the mortgage crisis, some commentators (starting with Martin Feldstein in 2008) have been discovering to their horror that a lot of mortgage lending is nonrecourse.  They think this situation is an invitation to moral hazard and argue that we should do away with nonrecourse mortgages and otherwise punish strategic defaulters (without ever saying how we identify a strategic default--not everyone who walks away from an underwater property is a strategic defaulter...)  Putting aside the issue that a lot of mortgages are recourse, I don't think these commentators have fully thought through the implications of doing so.  

First, if all mortgages became nonrecourse, it would have effects through the credit ecosystem.  It would hurt credit card lenders, auto lenders, student lenders, tax authorities, etc.  To the extent that it is harder to get out of mortgage debt, it makes default on other types of debt (even those that are already recourse and not dischargeable in bankruptcy) more appealing.  

Second, recourse doesn't necessarily mean a lot given how difficult it is to collect personal debts.  There's a big difference between owing a debt and being made to pay it.  The primary collection tool for personal debt is garnishment, but garnishment is not a particularly effective tool for recovering a large judgment--there are lots of federal and state restrictions on how much can be garnished from any single paycheck.  That means it takes a long time to collect a sizable deficiency judgment. 

Third, recourse would also make bankruptcy more attractive, as that would be the way to get out of large deficiency judgments.  (I'm sure the response is to curtail dischargeability).

Fourth, the foreclosure system would have to be overhauled if all mortgages were recourse.  If homeowners are to be liable for deficiency judgments on mortgages, then there need to be sufficient procedural protections to ensure that the foreclosure sale is not done at an artificially low price in order to create a larger deficiency judgment.  That probably means, at a minimum, no private foreclosure sales; all foreclosure sales would have to be conducted judicially, which imposes delay and expense on the process and results in higher mortgage costs/less credit availability.  The move to recourse might be self-defeating.

And finally (and maybe most importantly), recourse shifts the risk of property price decline from financial institutions to consumers.  As the system currently stands, risk and reward are asymmetrical.  If the property price increases, the gain is the consumers, while if it falls and there is negative equity, the consumer has a walkaway option.  Making risk and reward symmetrical, however, would impose the risk of sharp property price declines on consumers. 

This is a risk consumers are ill-equipped to handle.  There is no way to hedge or insure one's house price (yes, I know about thinks like the Oak Park and Syracuse home equity insurance programs, but those have never taken off nationally).  Housing price futures are done by MSAs or nationally, but the relavent geographic area is one's house, one's block, or one's neighborhood.  

A financial institution with a geographically-diversified lending portfolio is in a much better position to hedge--if it lends throughout a MSA (and the Community Reinvestment Act tries to encourage that through its definition of assessment areas), then it can hedge its overall portfolio.  Not perfectly, but far better than the consumer can.  The cost of such a hedge would presumably be passed on to consumers (unless some lenders chose not to hedge in order to gain market share--that's a regulatory issue), but that would be the efficient outcome.  Let the FI hedge its portfolio and charge the consumer for it rather than have individual consumers enter into ill-fitting hedges (or simply fail to hedge).  Why should we shift a risk to consumers that they are ill-equipped to handle when financial institutions are able to handle it much better? 

It's just too simplistic to argue that mortgages should be recourse.  There's a case to be made that recourse/nonrecourse status should be a freely-bargained component of mortgages, but there's also some good arguments for making nonrecourse the default status (mandatory or optional) because optimism biases will result in consumers systematically undervaluing nonrecourse status because no one ever buys a house thinking that it will end up underwater.  Either way, there's a lot of twists on the recourse/nonrecourse issue, and it should be approached with a lot of caution in terms of policy reform.  

Comments

How is it different from securities like stocks and bonds? Individual investors usually don't hedge. They take the 100% of the loss when the prices decline. Why must housing price declines be offloaded to someone else while securities losses are retained? Risk and reward has to be symmetrical. Otherwise you have too many people taking risks, as we have seen in the housing bubble.

TFB,

Mortgages are very similar to bonds. When a company is forced to sell, the bondholders are paid out first and the stockholders get whatever is left over, if anything. Similarly, when the price of a house declines the banks get paid first when the home is sold before the owner sees a penny. When the price falls below the loan value the borrower loses 100% of the equity (down payment) she put into the purchase. And just like a corporate bondholder, the lender gets nothing when the home/stock appreciates. There is no "upside" to lending, banks know this and should price the loan according to the risk.

Lenders ignored fundamental rules and allowed borrowers to purchase homes with no money down. In effect, banks became speculators, investors, in the real estate market. Why shouldn't they bear the brunt of their mistakes? They gave million dollar mortgages through wholesale brokers to people they never met and didn't know, often without income verification. Would you lend $1 million to someone you never met on their word alone?

Had banks required borrowers to put more skin in the game through higher down payments (read: owner taking on more risk), this "bubble" may well have been avoided altogether.

D

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed.

-Richard Thaler, "Underwater, but Will They Leave the Pool?", NYT Jan. 23, 2010.
http://www.nytimes.com/2010/01/24/business/economy/24view.html

-------------------
Note to banks: they're called "lending standards." Look into it. As D alludes to above, require higher down payments to insure borrowers have more skin in the game.


TFB: I agree with D, but I think there's an even simpler answer: a house isn't the same as a security. A house isn't just an investment. A security's does not have the consumption utility of a house. Everyone needs a place to live; securities investment is optional. Moreover, if I lose money on a security, it doesn't affect the wealth of my neighbors or the state of my community. There aren't the same externalities with securities.

Bondholders aren't exactly in the same boat as banks, though. I'd have thought that shareholders would be taken care of just a little bit better than that...

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