The ugly consequences of consumer protection

Millions of homeowners won’t be able to make their mortgage payments in the next five years, leading to a surge in defaults and foreclosures. It all started with the home-buying frenzy of 2003-2006. Many borrowers didn’t understand the contracts they were signing. Many others did know what they were doing, but thought that refinancing would always be an option. Congress now works on legislation that will let more Americans keep their homes – at the expense of increasing the cost of borrowing in the future and reducing the amount of credit available.

Four congressmen have introduced bills that would amend Chapter 13 of the Bankruptcy Code. All four share two features. First, they allow courts to cap the debtor’s obligations at the market value of the property. This provision is relevant because home prices have fallen since 2006, making it likely that in the near future the debts of a bankrupt consumer are worth more than his house. It is also relevant for homeowners who initially follow a “negative amortization” scheme, under which mortgage payments are less than accrued interest, so total debt increases over time, possibly above the value of the property.

The second feature allows courts to set interest rates below those in the original loan contracts – current legislation prohibits the modification of a mortgage on the principal residence (§1322(b)(2) of Chapter 13).

The bills therefore potentially reduce the obligations of homeowners who file for Chapter 13. This increases the interest rate that borrowers are willing to pay on their mortgages, as well as the fraction of borrowers who file for bankruptcy – because the legislation protects them from foreclosure. From the lenders’ point of view, receivables decrease and the proportion of loans in default rises, both of which increase the interest rate that lenders are willing to offer for any given loan – because the expected losses from defaults increase. Both the demand and the supply shifts make the cost of mortgages go up – their combination makes them go up even more. (A wealth of academic research, most of it by professor Michelle White, supports my analysis. Read this paper and this one.)

The New York Times says that it doesn’t make sense to claim that increasing consumers’ protection raises borrowers’ cost. Lenders – the newspaper correctly points out – would rather deal with a bankruptcy filing than with a foreclosure, because the losses from the latter are larger.

The NYT’s error comes from two places. First, it confounds the effects of the legislation on the amount of losses from defaults with its effects on the probability of default. The bills increase the fraction of borrowers that try a debt renegotiation (file for Chapter 13 bankruptcy) instead of letting the bank foreclose. This reduces the cost of default for the bank, because a foreclosure is costlier than a debt renegotiation. On the other hand, the proposed legislation increases the fraction of borrowers that default -- and banks always incur a loss when a mortgage goes bad. Total losses – the product of the average loss from default times the fraction of bad loans – may thus well increase.

The second error of the NYT is to confuse the banks’ losses from bankruptcy under the current legislation with those under the new one. Under the 2005 Bankruptcy Code, banks almost always incur a bigger loss from a foreclosure than from a debt renegotiation. If the proposed amendments lower the banks’ receivables from bankrupt consumers, it’s not clear that lenders prefer renegotiation to foreclosure any more.

And what’s wrong with foreclosures anyway?

Consumers with weak credit histories would be affected the most, because they are the most likely to default. Lenders would turn down applicants with the worst credit scores – the same ones who were getting risky mortgages not long ago, no questions asked. People shouldn't get loans they can’t afford in the first place, and Congress should certainly not provide the incentives to do so.

The proposed legislation encourages consumers to file for bankruptcy under Chapter 13. Under that section of the Code, the borrower proposes a repayment plan that pays off the arrears over five years. If the court approves of (i.e. confirms) the plan, the borrower gets to keep the house. Confirmation of the plan depends on whether the borrower has enough disposable income – after all expected expenses – to pay off her debt.

Chapter 13 is the right option for people who fall behind their payments because of a temporary financial setback. But everyone else would be better off filing for Chapter 7. Under this alternative, the borrower forfeits some home equity to pay off her debt. In many cases, banks foreclose and the mortgagees become renters. These are people who have neither enough equity to pay off their arrears nor enough income to afford the mortgage.

The sensible thing to do

So what should Congress rather do? First of all, settle on a bankruptcy text and stick to it. The latest overhaul of the Bankruptcy Code took place as recently as 2005. Regulatory uncertainty inhibits lenders.

Second, lawmakers should give the two parties in a contract more leeway to renegotiate their loans. I applaud the congressmen’s proposals to allow modifications of the terms of the original loans, but they could go further. For example, they should allow converting 30-year adjustable rate mortgages (ARM) into 50-year fixed-rate mortgages.

The modifications could be proposed by the court, but then they should require consent from both mortgagee and lender. Two of the bills under consideration -- the ones by Senator Durbin (D-IL) and Representative Miller (D-NC) -- allow the bankruptcy court to modify the terms of the loan without restrictions, not even agreement in writing between the parties. Giving such power to the court has at least two effects. First, it tilts the balance towards the consumer -- in a free negotiation between mortgagee and bank, the latter would have the upper hand. Second, it increases the uncertainty of the bank's payoffs. Both effects reduce the supply of debt.

Congress should also modify the Code so that the least creditworthy borrowers have more incentives to file for Chapter 7 instead of Chapter 13.

Going beyond the current problems, better ex ante disclosure would be welcome. Most borrowers don’t understand 95 percent of the legal mumbo jumbo on their contracts. Mortgage applicants should be given worst-case scenario simulations of their monthly payments.

We could also set a floor on “teaser” introductory mortgage payments. Hybrid ARM's, for example, start out carrying a low, fixed rate. Two to five years later the interest rate resets to a higher, floating level. Option ARM's let the borrower initially make interest-only payments, minimum payments (often below the interest accrued), or fixed, low-rate payments, also until the first reset date. Any of those schemes make mortgages affordable, but only for the first few years. Legislation could provide, for example, that initial monthly payments never be below 80 percent of the expected payment after the first reset date.

So here's a sensible policy on consumer protection: NO to protecting Americans who want to keep homes they can't afford; YES to protecting them from getting unaffordable mortgages in the first place.

Technorati tags:
economics, bankruptcy, mortgage, mortgage crisis, real estate