The Case for Mortgage Rewrites

A few people in comments were pushing back on my repeated insistence that a bailout ought to include some provisions to try to stem the tide of foreclosures and let people stay in their homes. I think to understand why this is a good idea, you need to step back and look at the logic of the foreclosure process. Banks are willing to lend people relatively large sums of money at relatively low interest rates for the purpose of buying a house precisely because if you don’t make your payments they can foreclose on you and take the house. Since a bank is a bank and not a real estate management company, their first choice is for you to pay your mortgage. But as a fallback, taking the house and auctioning it is fine, since under normal circumstances the amount of money a foreclosed house can secure at mortgage will, on average, have a close relationship to the size of the loan used to buy it.


Which is fine if only a few people are foreclosing. But check out this block in Miami that I originally found in December 20087 working on this piece for The Atlantic. You have six foreclosed houses on a single cul-de-sac plus two more on the little blocks immediately to the south. And if you go on Trulia here and scroll around, you’ll see that this particular cul-de-sac isn’t actually unusual in that part of Miami. When that starts happening, the properties have extremely little value at auction. Nobody’s going to pay much money for a house when several identical houses on the same block are also up for sale.

So the homeowners loses their homes, which is bad for them. And the banks, rather than being able to recoup the losses by taking over the properties, are left with a bunch of worthless houses, which is bad for them. And then this situation adversely affects the value of everyone else’s house in the area. And many of the foreclosed houses wind up left standing vacant, which is bad for the whole neighborhood in a whole bunch of other ways.

Now if this was just one city, you’d say, well, things will adjust — people will move in from the rest of the country to take advantage of the good deals. But it’s not just one city. It’s happening all across the economically depressed portions of the rust belt. But it’s also happening on the exurban fringe of essentially every growing metro area in the country. And it’s happening all across the sunbelt. Miami and Las Vegas are especially bad, but there are substantial foreclosure pockets all over the place. There’s no quick rebalancing.

In the long run, it’ll still all work out. You have X number of people and Y number of houses. We’re not all going to go live in tents while the houses all stand vacant. Instead, a bunch of people will lose homes they couldn’t afford and a bunch of homes will lose a lot of value, and then people will buy cheaper houses. But this is one of these situations where the adage that in the long run we’re all dead becomes relevant. That’s a lot of inconvenient dislocation. And since we know the end state will involve more-or-less the same set of people living, in the aggregate, in more-or-less the same set of houses and making, in the aggregate, lower monthly mortgage payments we ought to be able to short-circuit some of the dislocation. Have people stay in the houses they’re in right now. Adjust their monthly payments down to something they can afford, but that constitutes a better deal from the bank than what they’d be able to get by auctioning the property.

That’s win-win for the homeowner and the bank, and provides stability to the neighbors. It would also serve, if done on a mass scale, the “price discovery” function that we need to tell which of our banks are insolvent and which are solvent, and thereby get the ones that turn out to be solvent to be liquid again. In the days of yore (ah, yore) this sort of negotiation could be done between a bank and a homeowner, but the complexities of modern-day finance have made it harder to do in a consensual basis. What’s more, there’s a collective action problem, as bank would rather have the other banks do the renegotiating and then reap the rewards without paying the price. What’s needed is the heavy hand of the state, either in the form of a new agency or else in the form of bankruptcy judges to work this out.