A defense of mortgage modification in bankruptcy.

Todd’s Wall Street Journal op-ed makes many good points but it doesn’t address the main argument for bankruptcy reform. The basic problem posed by the housing crisis is that millions of people find themselves with negative equity and rationally abandon their homes. Banks have trouble seizing, maintaining, and selling these houses, and bankers will tell you (anyway, they’ve told me) that the rule of thumb they use is that a foreclosed house will lose fifty percent of its value. I am unaware of any studies that prove that this figure is correct but the anecdotal evidence is powerful. In some communities, abandoned houses become havens for drug dealers and squatters who strip away wiring and whatever else might be valuable in the house. The derelict houses reduce the value of neighbors’ houses, who then can be plunged into negative equity themselves, causing them to abandon their houses as well, leading to further degradation of the neighborhood, in a vicious spiral.

From a theoretical perspective, there are really two problems. First, bankers and mortgage holders are unable to negotiate contracts that provide for an automatic mortgage modification in the event that the value of the house falls below the debt. An optimal, complete contract would provide for such a debt adjustment, but it seems likely that bankers fear that any such provision could be too easily gamed, and so they prefer to renegotiate ex post if necessary or simply swallow the costs by having a policy of automatic foreclosure. Second, bankers and mortgage holders have no incentive to take into account the possible negative effects of mortgage default on neighbors.

As I have argued in earlier posts, the solution to such a problem in principle is mortgage modification. A banker does better by voluntarily reducing principal and interest than by foreclosing; however, big banks have traditionally refrained from renegotiating, perhaps because the transaction costs are high (smaller banks have traditionally agreed to renegotiate, by contrast). In the current climate, big banks are rethinking their earlier policy, but in any event it is hard to renegotiate with someone who has abandoned his house and disappeared.

If people can strip down their mortgages in Chapter 13, they will be less likely to abandon their houses, and this will have positive effects on their neighborhood. It is possible that such a rule could increase the cost of credit, as Todd argues, but the opposite effect is just as likely. On the one hand, banks might be reluctant to extend credit if they know that, in effect, repayment amounts will be reduced if housing prices decline, or banks will raise interest rates to cover this risk. On the other hand, if the result is a reduced incidence of foreclosure, then banks will do better rather than worse, and so interest rates should fall. If the right to modify the mortgage is limited to cases of financial crisis (which is not in the current bills), then the positive or negative effect on the cost of credit will be correspondingly smaller, minimizing a risk of disruption in the mortgage market.

We have learned from this crisis that every mortgage imposes potentially serious negative externalities on third parties. When someone defaults and abandons his house, he causes harm to others. The law currently does not punish that person or try to deter him from what is essentially a kind of pollution (like abandoning a car in the street); any attempt to do that would be impractical. So in a second-best world in which wrongdoers cannot be punished for the harm they cause others, restrictions on the contracts that bring about this state of affairs may well be justified. That is what bankruptcy law has always done; mortgage modification is a further development in bankruptcy law that would be justified in crisis (and possibly even normal) conditions.

Related Posts (on one page):

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