How Mortgage Relief Could Have Been Done Fairly: Profit Sharing As Delayed Penalty

If nothing else, it appears that Occupy Wall Street, despite the chattering class’ inability to decipher the obvious, has managed to sneak debt relief onto the List of Suitable Topics for Discussion. Steve Randy Waldman, in an interesting post, about fairness and mortgage debt relief argues that debt relief violates notions of fairness (boldface mine):

[Tea Party inspiration Rick] Santelli’s rant, quite legitimately, reflected a fairness concern. The core political issue has never been the quantity of debt the government would incur to mitigate the crisis. It was and remains the fairness of the transfers all that debt would finance. A fact of human affairs that proved unfortunately consequential during the crisis is that people perceive injustice more powerfully on a personal scale than at an institutional level. Bailing out the dude next door who cashed out home equity to build a Jacuzzi is a crime. Bailing out the “financial system” is just a statistic. So the anger Santelli channeled led to economically stupid bail-outs of intermediaries rather than end-debtors

If the Obama administration, or any administration, decided to encourage principal writedowns by having the government simply cover half the loss, that would be unfair. The Rick Santellis of the world might object more than I would, but that would be to my discredit more than theirs. Fairness should never be a policy afterthought. Widely adhered norms of fair play are among the most valuable public goods a society can hold. A large part of why the financial crisis has been so corrosive is that people understand that major financial institutions violated these norms and got away with it, which leaves all of us uncertain about what our own standards of behavior should be and what we can reasonably expect from others. When policy wonks, however well meaning, treat fairness as a public relations matter, they are corroding social infrastructure that is more important than the particular problems they mean to fix.

Where I disagree with Waldman is his characterization of mortgage cramdown. Most of the plans I read were similar to what I proposed:

We force lenders to readjust the value of the mortgage (both first and second mortgages) to current market prices (and reset them to a reasonable fixed interest rate loan), use the funds from TARP and HAMP to reimburse banks for part of the loss (e.g., fifty percent of the difference; they will have to take a loss), and, if the property gains in value, then the government gets half the profits on sale (we, the people, did help you not become homeless). If you don’t like the deal, you don’t have to enter the program, but millions of people would take it in a heart beat. It would also help lower housing prices, which still needs to happen, as well as take housing stock off the market (and future market).

The key part is the profit-sharing on the house sale, but I’ll get to that in a moment. Under this plan, everyone pays because everyone gains. Banks, by only eating half of the loss, don’t get walloped. The public at large* gains both through increased purchasing power (less money spent on a mortgage can be spent on porn other consumer goods) and by avoiding the social disruption and public burden from families being uprooted. Obviously, homeowners gain because they get to keep their homes.

Likewise, everybody also pays–no free lunch. Banks do take a haircut. The public pays as tax revenues are diverted to banks (i.e., we cover half of their losses). But bailed out homeowners also pay, just not right now since they can’t afford it. The payment occurs when they sell the house (assuming they do so at a nominal profit). Through what is essentially a 50% housing profit tax, a not-insignificant portion of future profits are destroyed. On the other hand, they did get their mortgage reduced and didn’t lose their home. This is only a delayed penalty.

I’m not familiar enough with the legalities of how such a plan would work, but, counter to what Waldman says, this strikes me as very fair.

*Despite being a full-bore wackaloon MMTer (sorta, anyway), in my personal life, I’m very frugal, and don’t assume any personal debt if I can help it. For the record, I rent, not own, so if anyone could bitch about the unfairness of my proposal, I certainly could.

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6 Responses to How Mortgage Relief Could Have Been Done Fairly: Profit Sharing As Delayed Penalty

  1. Ryan says:

    Question: Assuming a homeowner enters into a government cram-down program, what’s to stop them from selling the house to a 3rd party at the exact (crammed) value of the house and wiping out the government claim to 50% of future profits?

    For example, let’s say I bought a house for $350k and still owe $300k but the house is now valued at $200k. I enter the cram-down, and the bank and the fed each eat up $50k with the fed getting a promissory note for 50% of any sale value above $200k. I now sell the house (maybe during foreclosure I already re-settled) for the same price of $200k, giving no profit margin for the government to extract 50%. Ten years from now, the house is worth, say, $300k. How is the government going to lay claim to the $50k it would clearly get if I never sold it to a 3rd party? If the answer is that the government claim stays with the title, who is to decide for how long or under what circumstances?

    Alternately, what if I don’t do the above instant sell, but by the time I am ready to legitimately sell it (perhaps 10-20 years later) the price increase is no better than an offset of the inflation over the same period? Is it right for the government to claim 50% of an increase that added no value but was merely inflationary?

    These don’t apply to me, so they’re merely hypothetical, but they seem like good questions to ask.

    • Good questions. I’m not worried about the subsequent sale: the 50% give back exists to penalize the original owner (‘moral hazard’). People buy low and sell high as an investment strategy. To get around the issue of ‘selling’ it to a relative (or friend) to avoid the penalty, and then selling it back, you would probably need some legislation to prevent that (i.e., if the original holder reacquires the title, the fee still applies).

      Regarding the taxation of the nominal increase (i.e., no profit in inflation-adjusted dollars), that happens all the time with capital gains, so it doesn’t strike me as problematic (e.g., you pay capital gains on the nominal profit of stock sales). The ultimate goal is not to enable to homeowners to avoid a haircut, but simply delay it so they aren’t tossed out of their homes.

  2. Mike — I wouldn’t necessarily object to your proposal or call it unfair. My counterfactual was that the government simply eats half the loss that would otherwise have been borne by the homeowner or the bank, with no quid pro quo. But as I emphasized in the discussion of TARP, if we decide that some sort of intervention is necessary, we can mitigate fairness concerns by demanding sacrifice from those who are “bailed out”.

    As you emphasize, your proposal demands a sacrifice of potential upside from homeowners receiving principal writedowns. Whether it actually demands anything from banks turns on whether banks’ participation would be voluntary or compulsory. If voluntary, the banks would disproportionately select the least-likely-to-be-paid mortgages for participation, and the majority of the net benefit would be captured by banks. (The only “haircuts” they take would be losses they’d have experienced anyway in foreclosure.) But if participation were compulsory, there would indeed be a sacrifice by banks as well.

    Whether the “price is right”, whether the sacrifice demanded is sufficient to render the program fair to those who are ineligible for the program, is a detail we might or might not squabble over. But in principle, what you are proposing here is not what I was dissing.

    • Fair enough. I think (maybe?) we agree that there should be a penalty for homeowners.

      • Sure.

        The point is it is unfair to everyone else if the government extinguishes part of homeowners’ debt, but does nothing for people who are too poor to own homes, who are indebted via credit cards, who paid cash for or have paid off their homes (and suffer cost of home value declines just like those with mortgages), etc. I’d be a lot less upset about this than I am by, say, interventions to save large banks. But it’s still unfair.

        In your proposal, the government is not extinguishing debt but purchasing a call option. The question becomes whether and how badly the government is overpaying. But in principal, the call option could be sufficiently valuable as to cover the cost of the program, in which case there is no subsidy at all, just a form of refinancing. If so, that’s not unfair: it’s a trade of value for value that makes both parties better off (the homeowner because she can service her obligation under the new terms, the government because it has an interest in a good economy).

        Have you seen Martin Feldman’s proposal today? It is superficially similar to yours, but I wouldn’t support it. Its biggest problem is that it is voluntary to banks, which means only the most-likely-to-foreclose will be able to use the program. Also, the “sacrifice” he proposes from homeowners is simultaneously too modest and too troublesome. It’s too modest, because in many states mortgages are already formally full-recourse loans, it’s just historically deficiency judgements have been more trouble than they were worth to purse. For these loans, “making them” full recourse is changing nothing at all, except to the degree the government is more likely to actually chase defaulters. The transition to full recourse is too troublesome because it moves things in the wrong direction. The root of our problem is that borrowers are are imperfect judges of the risk and burden of indebtedness. Public policy should encourage financing arrangements in which the options and burdens are plain up front. Non-recourse debt is like that: if I don’t pay the loan, the thing I bought will be taken from me. Full recourse debt creates blood-from-turnip situations that public policy should discourage in consumer lending. So I dislike Feldstein’s proposal.

        Your proposal asks the government to effectively take an equity stake in a home rather than become a creditor to a homeowner. I like that much, much better (although, per Ryan’s point, the law would have to be designed so that people aren’t encouraged to game there way around paying a fair share to their partner in Washington DC.)

  3. Sailor says:

    It seems like an obvious idea. I thought of something like it, without bothering to articulate it, when the whole market first crashed. The way to stop the fraud mentioned by Ryan is to stipulate that any sale must be at “fair market value”. This is used to stop towns selling property for next to nothing to their buddies when they sell it to claim back- taxes. The threat of a possible case would probably be enough of a deterrent.

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