Monday, January 25, 2010

NYT on potential foreclosures

The New York Times has an interesting piece by Richard Thaler on the rational decision (strategic default) to stop paying a mortgage by households that are seriously "underwater" (in negative equity to us Irish folks). The focus is particularly on states in the US where nonrecourse mortgages are the norm. These are loans where the only liability recurring to the borrower is the house itself. There is also an interesting discussion of the contagion effects of defaulting, in that it may only be when people perceive defaulting to have lost some of its social stigma that a new larger wave of defaults will begin. One thought-provoking solution put forward by a Law Professor and Economist from Chicago involves a loan modification system, where banks would be forced to renegotiate mortgage payments so that the borrower would only pay a mortgage based on something like the new decimated market value of the property.

I imagine the discussion of strategic defaults is less relevant to Ireland given our tougher bankrupcy laws etc, although anyone with more knowledge of that system is welcome to correct me. The loan modification idea is surely something that could be taken on stream to help those in Ireland that took out mortgages around 2006/07.


Martin Ryan said...

Morgan Stanley recently decided to stop making payments on five San Francisco office buildings. That certainly suggests that strategic default coud be the rational thing to do in some cases. This was reported in a recent NYT magazine piece entitled: "Walk Away From Your Mortgage!"

I myself have little knowledge of the law in this area; but depending on how much (negative) equity has been built up, I can certainly envisage scenarios where it would be optimal to walk away from a mortgage (started circa 2007) and take out a new one on a property available in the current market. I guess the latter part is the catch: is it possible to take out a new mortgage after strategic default? Are there any reputational (credit rating) effects?

Maybe, as you suggest Fergal, the loan modification approach would be preferable. For one thing, it would save moving house (and any associated transport costs). It may preserve credit ratings. And it might also save on legal fees.

Ferg said...

I think the credit rating issue is certainly the most important one. The piece itself talks about the cost of rental as the opportunity cost, i.e. Thaler is likely assuming that people will not get another loan!! Your credit rating should have no bearing on your probability of getting a lease, so this seems an attractive strategy (save for the Irish aversion to rental beyond the age of 30).
Wondering if Liam or anyone else has heard of any proposals along the lines of loan modification making any headway in Irish policy circles?

Martin Ryan said...

The perceived social stigma of strategic defaulting reminded me of a paper by Benabou and Tirole:

"Incentives and Prosocial Behavior"

Also, here is a review of Obama's loan modification program from March last year:

Liam Delaney said...

Loan modifications essentially what is happening in Ireland Fergal but I don't know how banks agree terms with customers. It is hard to walk away from a mortgage in Ireland but it is also hard to foreclose on someone. So, what in effect is happening is rearrangement of mortgage terms, I assume by just allowing delayed payments, mortgage holidays and so on. I have no idea whether the financial regulator is looking closely at this area from the point of view of the monopsony position held by a bank over a customer with negative equity and also the potential systemic risk being built in by having so many essentially defunct mortgages in the system.

Martin Ryan said...

The Minister for Communications has said the Government is committed to assisting home-owners struggling to pay their mortgages.

The Minister said a panel of external experts will be established shortly to advise the Government on how to deal with the growing number of people who are failing to meet their mortgage repayments.