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Skin in the Housing Game

Monday, January 14, 2013

Recourse mortgages with significant down payments will stabilize the housing market, prevent speculative bubbles from forming, and limit taxpayer risk.

Editor’s note: this is the final installment in a series of essays about housing policy.

In the late 1980s, housing finance regulation focused on avoiding a repeat of what took place during the Savings and Loan crisis: government bailouts of institutions that had become insolvent by taking on too much interest-rate risk. Unfortunately, the new system, dominated by securitization, succumbed to the other major risk in mortgage lending, namely, house price risk.

Mortgage default risk is closely tied to the behavior of house prices. As long as house prices are not declining, mortgage defaults will be rare. If a borrower whose house has increased in value runs into financial difficulty and cannot pay the mortgage, it makes more sense for the borrower to sell the house and pocket the profit than it does to default on the mortgage.

Defaults on appreciated homes almost never happen. Thus, in an environment of rising home prices, underwriting standards tend to become lax, and other risk-management measures tend to be loose. When house prices are rising, lenders are not punished for poor judgment, mistakes, or even for making loans based on fraudulent claims by borrowers regarding their income and financial situation. As long as house prices continue to rise, borrowers either keep up with their payments or sell their homes and use the proceeds to pay off their mortgages.

When house prices are rising, the only real risk to the lender is from lending more than the value of the house to begin with. During the housing bubble, one observed ads for mortgage loans for 125 percent of the value of the home. Clearly, any lender who does this is asking for trouble. Also, any lender that is careless about appraising the value of a house for a refinance transaction where the borrower increases the loan amount is asking for trouble.

As long as house prices continue to rise, borrowers either keep up with their payments or sell their homes and use the proceeds to pay off their mortgages.

Apart from the examples in the preceding paragraph, a drop in house prices is a necessary condition for a lender to incur a loss on a mortgage. However, it is not a sufficient condition. The buyer may choose to continue making payments even if house prices fall. In some jurisdictions, notably in Texas, mortgage lenders are allowed to pursue borrowers personally to repay mortgages. So, if you have a $100,000 mortgage and the house is worth $80,000 when you hand the keys to the lender, the lender is entitled to come after you for the remaining $20,000. This is known as “recourse,” and it is worth noting that in Canada all mortgage loans are with recourse. This considerably reduces the propensity to default. Recourse also gives borrowers an incentive to think twice before taking on too much mortgage debt, because they know that they have more to lose in the event of default.

If a borrower has made a sizable down payment on a home, then a drop in home prices will not produce a default. If I put down $20,000 on a $100,000 home, and the value of the home falls to $82,000, my equity is still positive, and there is no reason for me to default. I would be better off selling the home than sacrificing my remaining equity.

The key point is that the fundamental risk in the housing market is tied to changes in house prices. This risk is shared among three parties: home purchasers, financial institutions, and taxpayers. Housing policy serves to allocate this risk.

When required down payments are high (say, 20 percent of the purchase price), home purchasers take a large share of house price risk. When financial institutions are required to hold substantial capital and loss reserves against the risk that they take in mortgage investments, then those institutions take a large share of house price risk. When down payments are low and capital requirements are low, then a decline in house prices is going to create stress at financial institutions, leading to government bailouts. Thus, taxpayers are at risk.

In retrospect, government policy in the decade prior to 2008 was effectively piling on taxpayer risk. Congress and regulators put pressure on financial institutions to broaden access to mortgage credit by lowering down-payment requirements. This allocated house price risk away from home buyers and toward financial institutions. Meanwhile, regulators approved maneuvers by financial institutions to minimize capital, notably through the creation of structured mortgage securities that earned high ratings from credit rating agencies. (See “Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008.”)

The only way to avoid a repeat of what we saw in 2008 is to make sure that home buyers take on some of this risk.

Capital standards play a big role in determining the shape of the mortgage market. Financial institutions and mortgage financing mechanisms that are favored with low capital requirements are at a competitive advantage. Invariably, growth will take place where capital requirements are weakest.

Mortgage capital requirements are very difficult to calibrate. If regulators make them too high, lenders will be driven out of the mortgage market and into other forms of lending, which may be even riskier. If regulators make capital requirements for mortgage lending too loose, they allow lenders to build up dangerous leverage, as happened in the years leading up to the financial crisis.

It is my belief, based on what we saw take place in the recent decade, that it is impossible for regulators to allocate house price risk effectively to financial institutions. The only way to avoid a repeat of what we saw in 2008 is to make sure that home buyers take on some of this risk.

I would like to see the following:

1. A shift away from non-recourse mortgages to recourse mortgages. That is, tell borrowers up front that they will not escape responsibility when the price of a house falls below the outstanding loan balance. This will discourage the sort of irresponsible speculation that took place in 2005 and 2006.

2. Ending government support for financial institutions that make mortgage loans for borrowers with down payments of less than 20 percent. This includes phasing out the popular FHA and VA loan programs.

Recourse mortgages with significant down payments will help to stabilize the housing market. It will help prevent speculative bubbles from forming. It also will help limit the risk that taxpayers are exposed to by financial institutions operating in the mortgage market. Of course, these proposals will meet a firestorm of opposition from the housing lobby. But I am not running for office. I am simply trying to suggest sensible approaches to policy.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for econlog, part of the Library of Economics and Liberty.

FURTHER READING: Kling also writes “Who Needs Home Ownership?” “Reforming the Housing Transaction,” and “The Risky Mortgage Business: The Problem with the 30-Year Fixed-Rate Mortgage” as part of this series.  Edward Pinto discusses “The FHA: A Home Wrecker.” Peter J. Wallison says “The CFPB Makes Mortgage Lending a Risky Bet.”

Image by Dianna Ingram / Bergman Group

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