Nightmares, Norms and Negative Equity

Thanks, Sarah, Dan, and everyone at Concurring Opinions for inviting me to guest blog.

For a Property professor, these are riveting times. The mortgage nightmare continues. As in much of the country, here in Minnesota, thousands of houses stand vacant and decaying. Parts of Minneapolis have been devastated. But the problem may have crested in the cities.

Not so in the suburbs. Five-year subprime ARM loans that were originated in 2004 and 2005, when McMansions were popping up in suburbs like dandelions in my lawn, are not due to re-set their rates until 2009 and 2010. If home values haven’t improved by then, many of those borrowers will have negative equity – that is, they’ll owe more than their homes are worth. That means they’ll be unable to re-finance for as much as they owe, because lenders won’t lend more than the house is worth.

Legal and economic institutions seem at a loss to cope with the crisis, but not for want of trying. There are lots of plans out there, but none seems satisfying. From an academic’s standpoint, it’s fascinating. Rational choice, on the one hand, and norms of fairness, on the other, are interacting in odd and sometimes surprising ways.

Homeowners with negative equity can be divided into four groups: those who can’t pay their loans, those who might not be able to pay their loans in the near future, those who can pay their loans but don’t want to, and those who can and do pay their loans.

Lenders and government agencies agree that the best choice for dealing with homeowners who can’t pay their loans is to re-work their loans so they can. Lenders don’t want abandoned, unsellable homes, and government agencies don’t want homelessness to spread. Moreover, the presence of one foreclosed house lowers the value of neighboring houses, and increases the risk of more foreclosures.

The FDIC and commercial banks are working frantically on plan to to re-work loans. The problem is that ultimately, in order to make these loans affordable, they’re going to have to be re-valued at the current value of the home. In other words, the principal owed on the house will have to reduced – in many cases, reduced by a lot. It’s an economically rational choice: everyone involved – the homeowner, the lender, the government agency — is better off.

But there are significant negative externalities, and not all of them are cold-bloodedly rational. First, by re-valuing homes now in danger of foreclosure, agencies and lenders could push other homes into danger. Think of it this way: if your neighbor’s nearly identical home is now worth $200K, yours probably is too. And that may push your home into negative equity, and if you need to refinance that ARM, you won’t be able to do it. So by saving one house from foreclosure, we may create the need to save another; and we’ve spread the crisis from our first group into the second. Foreclosures beget more foreclosures, but re-valuing homes to avoid foreclosure may also beget more foreclosures.

Second, the rational choice for our third group – the folks with negative equity who can pay their loans but don’t want to — is to pretend they can’t pay the loan, so that the lender will re-value the home and lower the principal due. And there’s plenty of evidence that those people intend to do just that.

Which, not surprisingly, infuriates the people in our fourth group – people with negative equity who can and do pay their loans. To them, it seems blindingly unfair that similarly situated people are treated preferentially, just because they are unwilling to live with the bad bargains they made. And yet, folks in the fourth group are no worse off whether or not people who can pay but don’t want to get their loans reduced.

But governments violate strongly-felt norms of fairness at their peril. The nightmare, and the tug-of-war between rational choice and social norms, continues.

You may also like...

7 Responses

  1. TJ says:

    Just a few thoughts:

    1. It seems there is not much of a difference between your first and second categories. Bottom line, these borrowers need some sort of bail-out. The first category may need more than the second, but it is a matter of degree only.

    2. I think discussing whether the third category “pretends” to not be able to pay loans misses the point a little. A lender can surely verify income, savings, and other factors before giving a break. The problem is that this third category of borrowers has lots of leverage over the lender–in states with non-recourse mortgages, the borrower can effectively threaten to default unless the loan principal is reduced, and even states with recourse loans the default threat still carries plenty of heft. The lender is then put in a bind: capitulate and it invites more borrowers (ex-members of the fourth category) to make the same threat; foreclose and it loses money through the costs of foreclosure.

    3. Given the problem outlined in (2), the best strategy for banks is to identify borrowers in the third category, and collude with them to pretend that these borrowers belong in the first category, so that the bank does not appear to be capitulating while still buying off the borrower.

    4. In short, I think you have the dynamics right, but I would put more gloss on your explanation. It is not for the benefit of the borrower, but the benefit of the bank, that the pretense goes on. And the people being deceived are not the banks–who either are fully aware of what is going on or at least wilfully blind to it–but those borrowers of the fourth category, who have every reason to join the third.

  2. Frank says:

    And here’s another angle, on behalf of those who don’t own homes: aren’t renters by and large poorer than homeowners? Rather than artificially inflating house prices, why not offer government help for food, health insurance, and shelter for those who need it?

  3. Nate Oman says:

    Is there any actual evidence that foreclosure rates are having ANY effect on homelessness? I would assume that people don’t go from McMansion to viaduct in one fell swoop, but rather go from McMansion to small home or from small home to apartment.

    It seems to me that one of the advantages of a bankruptcy approach to this is precisely that bankruptcy will hurt the borrowers by killing their credit rating and potentially threatening other assets. This provides an incentive for those who can stick the loans out to do so.

  4. Mark Edwards says:

    There is evidence that foreclosure are increasing homelessness. I suspect you’re right that McMansion dwellers may not face homelessness, but one point of the post is that the mortgage crisis hasn’t yet hit the McMansions as hard as it will. But especially for lower-income people, homelessness seems to be increasing in areas hit hard by foreclosures.

  5. Nate Oman says:

    Mark: I am not sure that this shows that foreclosures are causing an increase in homelessness. For example, an economic downturn may be causing both increased foreclosures and increased homelessness, even though all of the foreclosed residents are getting rentals. I doubt that this is actually the case. The USA Today story talks about renters losing their homes because their landlords were foreclosed on, but on the whole it simply notes rising homeless levels and claims that foreclosure is one of the chief causes.

    I perseverate on the point only becuase so much of our current political discourse is getting invested in the notion that home foreclosure is an unmitigated evil and one that can be pointed to as the cause of numerous creeping social ills.

    I am not convinced this is the case, and regardless a sensible policy response demands that we remain clear on what is and is not caused by foreclosure.

  6. Miriam Cherry says:

    What’s funny is that only five years ago, in some markets (Boston, for example), everyone complained there was no where to get a place to live, and that all the housing was so out of reach as to be completely unaffordable.

    Now that prices are dropping it hurts those that own, but may benefit those that waited or those that earlier simply couldn’t afford it. Now I’m not saying that negative equity is a good thing… but… for some group of people this does provide an opportunity. Because people still need places to live.

  7. Mark Edwards says:

    Nate and Miriam: good points, both. I agree that foreclosures may not be an unmitigated evil, any more than business failures are unmitigated evils. Some businesses obviously should fail, and the market — if it is functioning correctly — tends to shake those businesses out. So too, some people shouldn’t own the homes they bought. They can’t afford them and shouldn’t have bought them, and in some ways foreclosures are simply a market correction that makes more homes affordable for others. That’s all to the good.

    On the other hand, just as the external effects of some business failures are so negative that we consider them “too big to fail,” it seems to me that the social effects of some foreclosures are so negative that it is in our rational self-interest to prevent them if we can. Foreclosures are, in a way, a type of nuisance, in that their negative effects spread throughout neighborhoods, lowering property values. In addition, if it is true that foreclosures increase homelessness, and I suspect that it is, the negative social effects are magnified (particularly if there are kids involved).

    But how do we decide which to let fail and which to save? And how do we save some without spreading the problem, or benefitting some who shouldn’t be benefitted? Those are the questions the FDIC and commercial banks are trying to answer. Interesting times.