More on Housing

So apparently I'm not as original as I think. Nouriel Roubini has also suggested "breaking every mortgage contract."

Considering the fact that he's a lot smarter than I am, maybe we should take this idea seriously. But let's think about an asset other than houses to see if it clarifies the situation any.

Imagine that we all invest in gold. Whenever we want to save, we go to the goldsmith and buy a couple of nuggets. First, let's say we all pay cash for our gold. Now let's say there's a bubble in gold prices. I bought $50,000 worth of gold at the top of the bubble. But then the bubble burst, and now it's only worth $30,000.

There are really only two things that I can do. If I think the price is going to go back up, I can hold onto the gold and hope to sell it for more (than it's worth now) in the future. Or I can just sell it now and take the $20,000 loss. If it's clear that the gold only has an intrinsic value of $30,000, and I need the cash for whatever reason, then it makes sense to sell it now and realize I'm not the best precious metals investor in the world.

Now let's imagine that we all borrow the money to buy the gold. It's a loan backed by collateral, so that if we fail to make payments the bank comes and takes our nuggets. Maybe I bought the $50,000 worth of gold with $5,000 down and a $45,000 loan from my local bank. But now that gold is only worth $30,000 and I'm faced with a choice. I can keep paying the loan, or I can default. If I keep paying, then I will eventually pay much more for the gold than it is worth. If I default, the bank comes and takes my gold and I'm out $5,000. But in this case I'm out a lot less than if I had paid cash. The bank, on the other hand, now has $30,000 worth of gold that it can sell but faces a loss of $15,000 on the loan.

Now let's say the government steps in and "breaks every gold contract" so that the principal is reduced by however much the price has fallen. In our case, the price of gold has gone down by 40%. If the principal on the loan is reduced by this much, the new amount would be $27,000 and I would have $3,000 worth of "equity" in my gold. Now the bank will only go for this plan if the costs of seizing and selling the gold are larger than $3,000 ($30,000 - $27,000). Based on what I've read about the foreclosure process, it seems that costs are generally larger than 10% of the "true market value."

So as long as foreclosure costs are significant (larger than the average percent of the down payment), then the idea of reducing the principal on all mortgages will benefit everybody. Banks would prefer doing this only for mortgages with little to no equity on the original mortgage, but that doesn't seem like a politically feasible solution as it would benefit the least responsible borrowers.

The reason we need to do this is because we convinced ourselves that an asset that most people buy and all banks finance was worth more than it really was. The value was never there and now that we realize it, the only rational thing to do is rewrite all the loans that were based on the inflated value. The data to do this is out there. We can simply adjust every mortgage principal based on how much prices have fallen since the mortgage was written in that particular zip code.

Reducing the monthly payments for borrowers will only help people who plan on staying in their house for the entire length of the mortgage (then the difference between principal and interest is irrelevant). But for people who want or need to move, reducing the interest will have no effect. These people will still be faced with selling their house at some price less than their mortgage balance and either having to declare bankruptcy or coming up with the cash somehow.

The fact is, one of the main ways the country recovers from recession is for people who are unemployed or underemployed to move to areas that have jobs. If they are pinned to their house because they can't sell it for what they owe on their mortgage, then the recovery will take that much longer.

Remember, we had the same problem in the early stages of the Great Depression. In that case, the asset wasn't houses, but stocks. Individuals and banks were highly leveraged in their stock portfolios. When the stock market crashed and everybody received margin calls, the system blew up and thousands of banks went out of business over the next couple of years.