Mortgage Morass

On March 4, 2011, the New York Times described a settlement ("settlement") proposed by a consortium of state attorneys general (AGs) to large mortgage servicers. The claims to be settled reportedly relate to failures to follow existing procedural rules relating to the foreclosure process. The settlement would make dramatic changes in those rules, and reportedly require a mortgage loan principal reduction program of $20 to $25 billion. Negotiations over the settlement are continuing despite servicers reaching an agreement with bank regulators on penalties and procedural changes related to foreclosure processing deficiencies. These negotiations continue to create uncertainty in the housing market and have the potential to stall foreclosure proceedings nationwide. The purpose of this essay is to review how such a settlement would affect the housing market and the larger economy.

Photo credit: sean drellinger, via flickr

Although the settlement is a long and complex document, two key components stand out. First, it appears lenders would be required to write down principal whenever doing so meets certain criteria, regardless of the level of borrower distress. Although the settlement is silent on the issue, press reports indicate that the AGs would require the servicers to use $20 to $25 billion of their own funds to finance these write-downs. Second, the settlement would add a host of additional procedural requirements that must be met before foreclosure may proceed. For example, each servicer would be given "an affirmative duty to thoroughly evaluate borrowers for all available loss mitigation options prior to foreclosure," including short sales. In addition, borrowers would be given the "opportunity to provide evidence that the [net present value] or eligibility calculation was in error," in which case said borrower "can request that a full appraisal be conducted of the property by an independent licensed appraiser. . . ."

We find that a settlement along these lines would generate few benefits and entail significant unintended negative consequences for housing and financial markets. The settlement would, ultimately, harm the broader economy and extend, rather than end, the foreclosure crisis. The settlement, including its delay of foreclosures, would harm the broader economy by: stalling construction of new homes; reducing consumer spending and investment; and reducing credit access and economic growth.

Ultimately, the settlement will extend the foreclosure crisis.

The United States undoubtedly faces a continuing foreclosure crisis. RealtyTrac, a housing market data provider, reported in January 2011 that nearly three million homes received foreclosure filings in 2010. In addition to the current foreclosures, a substantial number of potential foreclosures will occur in the next several years. CoreLogic, which provides and analyzes data on the housing market, estimated that nearly 23 percent of all mortgages are underwater as of the third quarter of 2010. This number spikes in the areas hardest hit by the mortgage crisis, particularly California, Florida, Arizona, and Nevada, where the Case-Shiller index has fallen by around 40 percent since the peak of the real estate bubble.

The settlement would delay the resolution of this crisis by keeping homes in foreclosure status. Even as rents rise relative to home prices, the continued overhang of shadow home inventory—that is, homes occupied by borrowers that cannot afford them pending political resolution of various foreclosure moratoria—prevents home prices from rising as much as they otherwise would in the face of increased demand. This postponement in recovery can weaken financial systems, stall the construction of new homes, reduce consumer investment, and restrict access to credit. The actions contemplated in the settlement would aggravate the postponement of housing market recovery, and thus have broad and adverse implications for the U.S. economy. We address the elements of this argument in the sections below.

Stalled Construction of New Homes

Until the bottom of the housing market is reached and a consistent and reliable upward trajectory in housing prices is established, new housing construction will not proceed. A 1994 study by economists Denise DiPasquale and William Wheaton explains that residential construction is a linear function of new housing prices. Using data from the Commerce Department, Freddie Mac, the Federal Home Loan Bank Board, and the American Housing Survey, the researchers conclude that the industry is driven by changes in housing prices as opposed to housing price levels.

A 1999 study by economist Dixie Blackley extends this research using aggregate annual data from 1950 to 1994 on new housing starts in the United States, and corroborates the evidence that residential construction is a linear function of housing prices. In the long-run, new housing supply is price-elastic—an increase in housing prices will lead to an amplified increase in new housing starts.

These findings are also supported by the 2000 study by economists Christopher Mayer and Craig Somerville. Using data on national housing starts, they find that increased prices in the housing market lead to an attendant increase in housing stock and a large increase in housing starts. Their findings strengthen the claims that (1) changes in housing market prices, as opposed to levels, lead to new construction, and (2) new housing supply is price-elastic.

By injecting uncertainty over when the housing market will reach bottom, foreclosure delays undermine the incentives of construction companies to invest. That postponed investment lowers economic activity in the short run and further weakens the economic recovery that is underway. Indeed, a recent Federal Housing Report showed new home construction has fallen to the lowest level since April 2009.

Reductions in Consumer Spending and Investment

Households value greater certainty in markets when making their spending decisions. In the aggregate, the literature regarding mortgage foreclosure and individual investment decisions points to the need for speedy resolution of the foreclosure crisis.

Indeed, one could argue that the uncertainty produced by the foreclosure moratorium has already harmed the housing market. For the past several months (possibly as the result of various foreclosure moratoria) housing has become increasingly disconnected from the recovery in production and jobs that is occurring in other sectors of the U.S. economy. Housing sales, prices, and starts remain low or declining, despite the signs of recovery elsewhere.

In a 1983 paper published before he became chairman of the Federal Reserve, Ben Bernanke posits that a temporary increase in uncertainty can cause a sudden drop in investment spending. He discusses the trade-off between the benefit of information (that is, knowing that an investment will bring reliable returns) and the cost of delaying investment. Investors will often postpone projects at a cost in order to wait for a safe time to make a commitment. Bernanke shows that even a single unusual event can make investors less certain about the nature of the market, and thus cause them to adjust their behavior toward a higher degree of caution.

In 1990, Christina Romer, the former chair of President Obama’s Council of Economic Advisors, applied this logic to explain how uncertainty disrupted consumer spending on durable goods during the Great Depression. Among other evidence, she presents a regression analysis that quantifies the impact of stock market variability on a measure of durable goods consumption. By controlling for the wealth effect of declining stock prices, Romer finds that the variance in stock prices, and not the actual decline, was responsible for the huge drop in consumption and investment at the onset of the Great Depression. She estimates that a doubling of the average variability of the stock market depresses consumption of durable goods by about seven percent.

Expect interest rates on mortgages to increase—and demand for new homes to fall.

Debt overhang effects from failing to resolve delinquent loans can adversely affect long-run consumption through an additional leverage channel. A 2006 study by economists Ray Barrell, Philip Davis, and Olga Pomerantz analyzes the effect of a financial crisis on consumption. They demonstrate that the macroeconomic effects of a crisis are aggravated by high leverage, especially as an effect of a high debt-income ratio. The researchers empirically test the effects of financial instability on consumption in 19 OECD countries, finding that the loss to consumption due to financial crisis ranges from 4.5 to 9.5 percent annually. They explain that household balance sheets, especially those that entail high debt-to-income ratios, are a large contributor to this drop in spending. Lax credit constraints will ease falls in consumption in the first year following a crisis, but the effects of high leverage and debt-to-income ratios causes a large decline in consumption in subsequent years. The researchers explain that "rapid resolution is often thought better than forbearance which leaves bad loans outstanding and can heighten moral hazard, worsening the eventual costs to the taxpayer while also slowing economic growth."

With respect to the effects of foreclosures on consumer wealth, through their short-term effects in depressing home prices, economic theory suggests that transitory changes in housing prices (resulting from temporary selling pressure related to foreclosures) would not affect perceptions of long-term wealth, and thus would not have a significant effect on consumption. Furthermore, even the short-term effects of foreclosures on house prices, under the current foreclosure regime, would be modest.

Credit Access and Economic Growth

Economic research also suggests that government intervention into the allocation of loan losses can have negative impacts on both credit access and economic growth. In their 2005 examination of Italian credit systems, economists Tullio Jappelli, Marco Pagano, and Magda Bianco find that judicial inefficiencies in processing financial claims lead to restricted access to credit. Their finding can be translated to the settlement at issue here, which involves an overlapping of new foreclosure procedures onto existing state foreclosure laws. This will certainly create uncertainties and inefficiencies in the legal system surrounding contract enforcement and foreclosure. Understanding these new risks, lenders will respond by limiting access to credit. The restriction of credit will put upward pressure on interest rates. The increasing cost of credit will put further downward pressure on home prices, thus, exacerbating the current housing crisis. Alan Greenspan recently suggested that our current stagnant economic recovery is due precisely to the type of government activism that the proposed settlement exemplifies.

In another 1983 paper, Ben Bernanke explains why a disruption in the credit markets has protracted negative macroeconomic effects. He cites bank disintermediation as the cause for decreased output during and after the Great Depression, referring to the simultaneous weakening of borrowers’ balance sheets and tightening of bank credit supply. He uses a simple regression analysis to show that during the period of 1921 until the bank holiday of March 1933, credit contraction had a large, negative, and statistically significant effect on output. Bernanke infers that the credit effects from bank failures depend on the time it takes to repair disrupted channels of credit and rehabilitate insolvent debtors. A more detailed 2003 study of the Depression by Charles Calomiris and Joseph Mason confirms Bernanke’s claim, showing that the effects of credit contraction persisted for years after the shocks of 1930-1933.

Bernanke’s hypothesis is further confirmed by a 2005 study by economists Ali Anari, James Kolari, and Joseph Mason. They extend his research by showing how the slow liquidation of poor assets during the Great Depression exacerbated financial disintermediation, which triggered both transitory and permanent adverse macroeconomic consequences. They conclude that the endurance of the Great Depression into the late 1930s can be explained largely by the sluggish liquidation of distressed assets.

Given the large number of existing foreclosures and the potential overhang of another seven million foreclosures, it is reasonable to argue that we are facing a situation similar to the one that Bernanke and Anari, Kolari, and Mason analyze. We have already seen that zero interest rates and two rounds of quantitative easing have done little to spur lending by financial institutions. This likely is due to the uncertainty regarding the value of the delinquent mortgage assets held by financial institutions. A settlement that raises critical questions—such as the amount of time new foreclosures will take under the new rules, and whether strategic defaults will cause a net increase in defaults—would continue to slow economic growth.

THE IMPACT ON INTEREST RATES AND ACCESS TO CREDIT

Furthermore, with respect to its effects on the buy side of the housing market, the proposed settlement could further delay the resolution of housing distress by raising interest rates on mortgages significantly, and thus reducing the demand for homes. A 2005 study by economists Charles Himmelberg, Christopher Mayer, and Todd Sinai establishes that interest rates have a powerful effect on housing prices. The proposed settlement would inevitably raise the costs of lending for new mortgages. The mandated write-downs are not funded by the government, but would be funded by servicers and/or investors, and so amount to a new tax on mortgages. The costs of that tax would be passed on to borrowers in the form of higher mortgage rates. If mortgage rates go up, demand for homes (and thus home prices) will stagnate or decline. That effect is counter to the desires of policymakers to raise home prices. We estimate the costs of the settlement and distribute those over new mortgage originations. Even conservative calculations show that mortgage rates are likely to rise by roughly a quarter of a percent in response to such a policy, harming mortgage markets even further.

***

Press reports on the settlement have indicated that its terms are the product of state AGs and the Consumer Financial Protection Bureau, and not the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, or the Federal Reserve. Unfortunately, the terms of the settlement appear to reflect the absence of regulators with broad understanding of the housing market and its relationship to the national economy. Although mandating principal reductions certainly seems "pro-borrower" on the surface, there is substantial economic research that suggests that the benefits to borrowers would likely be illusory, and that the costs to the nascent economic recovery would likely be significant.