Tuesday, January 27, 2009

Why Cramdowns Are a Bad Idea

There is something of a populist sentiment that says we need to do more for struggling homeowners. To some degree I agree but I think what Speaker Pelosi and others are proposing of full cramdowns is a complete disaster. In their current form, bankruptcy judges would be given the authority to cram down the mortgage to the current appraised value (ostensibly you would have to either be delinquent by a certain period and/or underwater).  End of story.  Why is this bad one might ask?  Well, one, there are terribly perverse incentives.  I think a lot of homeowners will be musing to themselves how their mortgage payments are terribly high and wouldn't it be nice if they missed a payment or six so they too could get a cramdown.  

But this is comparatively trivial.  If you were a bank and you were forced to cram down your mortgages with no share of the upside how would you make money?  Well, by raising interest rates on new homebuyers.  What effect will this have on home prices?  If you raise the cost to borrow appreciably, which cramdowns would likely do, you would depress home values further, as people would be able to afford less then can even now.  By the way, this might put more houses underwater.  

A better route would be a policy where there is shared risk and shared reward.  A homeowner who gets a cramdown should forgo some of the upside, not all of the upside.  An own-to-rent proposal a la Dean Baker where the undewater owner is reduced to a renter in lieu of foreclosure would give the owner no incentive to maintain the property.  

If we are going to piss away more TARP money this would be a good area to spend it.  Create a program: Bailie Mae.  Bailie would facilitate cram downs by purchasing part of the mortgage.  In order to have your mortgage purchased, the lender must agree to a cramdown.  When the house eventually sales, any profit is split into thirds, one third to the gummint, one third to the lender, and one third to the home owner.

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