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A million foreclosures

January 30th, 2008

The news that over a million homes went into foreclosure in the US in 2007, affecting about 1 per cent of all households or around 3 million people, supports the view that foreclosure has taken over from bankruptcy as the primary mode of financial catastrophe.

As with bankruptcy, however, the high frequency of financial distress is partly offset by the fact that US law and standard contractual arrangements are more friendly than in other countries. Compared to those in other places (at least in Australia) US mortgage contracts have commonly favored borrowers in two important ways. First, they have been fixed rate contracts with no, or limited penalties, for early repayment. That means that borrowers can stick with their fixed rate if market rates rise, but can refinance at lower cost of market rates fall.

Second, most mortgages are non-recourse, meaning that the lender can take the house but cannot recover the debt from the borrowers income or other assets. That means that once the value of the house falls below the amount owing (equity becomes negative) the borrower can walk away from the house and the debt. As Felix Salmon notes, the difficulty of pursuing deficiency payments means that most loans are non-recourse in practice even if the contract says otherwise

In the jargon of financial assets, the standard contract gives borrowers both a put option on the house (the ability to walk away) and a call option on the debt (the ability to pay early). Both of these make the contract more valuable to borrowers and less valuable to lenders. There’s quite a good discussion of all this from Tanta at Calculated Risk, though the author makes heavy weather of the put option and seems to me to be unreasonably exercised about the fact that households are now treating their debts to banks with the same calculating attitude that corporations have long shown to their workers and other creditors, paying them if it is profitable to do so and defaulting otherwise.

The relatively generous treatment of debtors in the US seems to illustrate, at the national level, a pattern found among US states. Pro-debtor institutions are, in political terms, a substitute for redistributive taxation.

Where credit is easy, and the consequences of non-repayment are not too drastic, households can maintain consumption for long periods even when their income is falling. So, the political resistance to pro-rich policies is much less sharp. The massive increase in income inequality in the US since 1970 has coincided with an equally massive boom in consumer credit.

The obvious question is whether this political equilibrium can survive. We’ve already seen a tightening of bankruptcy laws in the US and a big shift away from fixed-rate loans. Almost certainly, in the wake of the current debacle, lenders will act to protect themselves from jingle mail by lending lower proportions of house value and demanding additional security.

But, on the other side of the coin, there are indications that the willingness of average Americans to put up with a system in which virtually all the gains in income of the last few decades have gone to the top 10 or 20 per cent of households with the top 1 or 2 per cent getting the lion’s share. The candidate who has pushed the issue hardest, John Edwards, has not done well in the race for the Democratic nomination, but there seems to be general support for letting all or most of the Bush tax cuts expire, which would be the first effective tax increase for the rich in quite some time.

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  1. cb
    January 31st, 2008 at 04:33 | #1

    One quibble – mortgages are only non-recourse in six US states, though they include the rather important case of California. And I’m pretty sure it only applies to the first mortgage. Many of the households going bust had simultaneous second mortgages (piggybacks), which can be subjected to a deficiency judgement. In fact I expect we will hear more about conflicts between first-lien and second-lien lenders before too long.

  2. Donald Oats
    January 31st, 2008 at 04:39 | #2

    Interesting analysis, especially the put option part (I hadn’t explicitly thought of loans in those terms before).
    As part of the price paid for insomnia, two factoids gleaned from Sky News while I was reading the above: a) Housing repossessions in England hit a high of 76,000 in the year 1991; b) John Edwards withdrew from US presidential race.
    On (a), given the relative populations of England and USA, it gives a sense of how big the one million home foreclosures truly is. Scary big.

    BTW, these sorts of events, while relatively rare, are economy changing in impact. When economists attempt to quantify the costs of dealing with climate change, how do they go about accounting for this type of uncertainty (or is it too hard to deal with)?

  3. January 31st, 2008 at 06:42 | #3

    it’s long past time for another constitutional convention in the usa. this mildly modified georgian monarchy model isn’t working very well.

    the place has gone to hell, economically, since i left. politically, dubya is just trying to do to ‘murricans what they’ve been doing to everyone else. i guess that’s globalization.

  4. observa
    January 31st, 2008 at 07:09 | #4

    Looks like we’re all about to address the housing affordability crisis.

  5. January 31st, 2008 at 07:09 | #5

    Donald, I believe “factoid” means a “fact” that’s commonly believed to be true but is in fact wrong. I don’t think that’s what you meant?

  6. January 31st, 2008 at 07:45 | #6

    I have long suspected that the widespread existance of fixed interest loans in the USA (which allow early repayment) are symptomatic of a significant structural problem. What I have never seen clarified is whether they are the result merely of industry norms and competitive pressure of if they are the product of legislation favourable to borrowers. JQ seems to suggest the latter although I’m not yet entirely satisfied with the detail.

    I do know that in the 1970s when inflation took off in the USA (following Nixons end to the gold standard) the nominal interest rates on loans were capped in some states (often at single digits). The result was an effective shutdown of credit markets in those places due to the fact that such nominal rates of interest were representative of negative real rates in the prevailing inflationary environment. So it does seem that dumb laws and dumb policies abound.

  7. observa
    January 31st, 2008 at 12:01 | #7

    On second thoughts affordability might still be a problem because we old buggers are not keeping up, even with higher interest rates curbing some of the demand http://www.news.com.au/adelaidenow/story/0,22606,23137340-5006368,00.html
    You lot keep jamming the immigrants in at 150k a year and us old buggers will go on holidays and watch our rates climb a bit more.

  8. observa
    January 31st, 2008 at 12:10 | #8

    Just a suggestion. Perhaps you could make the entry test a bit tougher http://www.news.com.au/adelaidenow/story/0,22606,23133395-2682,00.html?from=public_rss

  9. Tony G
    January 31st, 2008 at 12:43 | #9

    Terje, they still had capped housing loans in Australia up until the mid 1980s.

  10. January 31st, 2008 at 14:02 | #10

    Fascinating post, Prof. Quiggin.

    I’ve often heard the tolerance of higher inequality in the USA ascribed to cultural factors (in a nutshell, white people don’t like their taxation funding welfare for people other than whites – less of an issue in more culturally homogenous countries in Europe and Asia. Distasteful and offensive, sure, but plausible at first glance).

  11. Donald Oats
    January 31st, 2008 at 16:33 | #11

    Thanks “Your friendly pedant” (#5) for correcting me – I did indeed mean fact.

  12. cb
    January 31st, 2008 at 16:52 | #12

    Terje,
    Yes, the US system of long-term fixed rate mortgages that can be refinanced cheaply is the consequence of a massive government intervention in the market — the government-sponsored enterprises Fannie Mae, Freddie Mac and the Federal Home Loan Bank system. So-called conforming mortgages are packaged up in securities, which investors will gladly buy because they are guaranteed by Fannie or Freddie, which people believe to be guaranteed by the US government. Subprime-backed securities did not have this guarantee and look what happened.

    Every other country that has fixed-rate loans has large prepayment/refinancing penalties (except Denmark, which has a similar amount of government intervention to the US).
    A good paper on the subject is: Susan Wachter and Richard Green, “The American Mortgage in Historical and International Context.” Journal of Economic Perspectives Vol. 19, No. 4 (2005).

  13. January 31st, 2008 at 17:20 | #13

    Thanks for the info TonyG and CB.

  14. Ikonoclast
    January 31st, 2008 at 19:42 | #14

    Quite frankly, I think variable interest loans stink. The notion of allowing a change in the price of a product after its sale is a typical capitalist confidence trick.

    Two areas where we need a major tightening of laws are the areas of finance and advertising. Those industries are packed wall to wall with shonks, liars and outright criminals.

  15. Ernestine Gross
    January 31st, 2008 at 20:56 | #15

    S&P made some new discoveries about the past which caused them to revise their ‘independent risk assessment’ (about the past?).

    Possible financial market reactions to the S&P activities are discussed by others who are said to have influence on ‘market sentiments’. It doesn’t look good.

    http://www.bloomberg.com/apps/news?pid=20601103&sid=aS_DNKFmqEx4&refer=news

    S&P is owned by McGraw-Hill Companies (which dominates the Finance textbook market).

    McGraw-Hill is still ‘creating value’ for its shareholders. http://www.google.com/search?hl=en&q=McGraw-Hill+Companies&btnG=Google+Search

    Independent shareholders who can see the problems created by rating agencies presumably know what to do. Unfortunately, indirect shareholders (super funds) are almost powerless (switching to cash is about the only possibility but, like interest rate cuts, it is not a selective strategy). The alternative is for governments to legislate rating agencies out of business. Any other suggestions?

  16. January 31st, 2008 at 21:42 | #16

    Quite frankly, I think variable interest loans stink. The notion of allowing a change in the price of a product after its sale is a typical capitalist confidence trick.

    Then don’t get a variable interest rate loan.

  17. January 31st, 2008 at 21:44 | #17

    And besides the government sector is more likely to play confidence tricks that entail delivering something different to what was promised or changing the price of what was promised. So if capitalists are naughty or evil governments are several orders of magnitude worse.

  18. peterd
    January 31st, 2008 at 23:13 | #18

    Terje wrote:
    “I do know that in the 1970s when inflation took off in the USA (following Nixons end to the gold standard)…”

    Do you mean by this, Terje, that you consider the end of the gold standard to have been the CAUSE of infation in the 1970s?

  19. wilful
    February 1st, 2008 at 11:01 | #19

    Donald, pedant, “factoid”, being a new word, is still up for debate. My dictionary gives it two meanings, the first being something that is believed to be true, the second being a small, trivial fact. So Donald you were using it correctly in the second sense.

    Noun

    factoid (plural factoids)

    1. An inaccurate statement or statistic believed to be true because of broad repetition, especially if cited in the media.
    2. A small insignificant fact, but still interesting. (Note: Refer above to the meaning of the suffix. It’s ironic that the very definition of factoid has itself come to be a factoid.)

  20. February 1st, 2008 at 12:18 | #20

    Terje writes “Then don’t get a variable interest rate loan”.

    There is an American joke about a man who always played poker and always lost. A kind soul told him that it was a crooked game, only to be told that he knew. Then why go? “It’s the only game in town”.

    It’s rather like the simplified version of the three laws of thermodynamics: you can’t win; you can’t even break even; and, you can’t get out of the game.

    Almost the only way for an individual to arrange fixed payments is on the back of these favourable circumstances: if you are in business for yourself, and if it is structured as a company, the company arranges a mortgage from itself to you on those terms and gets the capital by securitising the payments you make to it, placing the securities through its banking connections.

  21. Ian Gould
    February 1st, 2008 at 22:04 | #21

    “Do you mean by this, Terje, that you consider the end of the gold standard to have been the CAUSE of infation in the 1970s?”

    If I can be forgiven for answering for Terje – that’s exactly what he means.

    I have discussed this with him in the past and don’t consider it a fruitful line of conversation.

  22. Ian Gould
    February 1st, 2008 at 22:30 | #22

    So what percentage of “foreclosure filings” actually translate into people losing their homes?

    According to the article the “filings” include such things as “default notices”.

    Let’s find out how bit the problem really is, if only so we can make a valid comparison with the UK figure provided by David Oats.

    Looking at the map accompanying the article, it’s striking that amongst the worst affected states are the swing states of Florida and Ohio and Nevada which used to be safe Republican but has been drifting toward the Republicans over the last few elections.

    It’ll be interesting to see if this becomes an election issue and if Bush is blamed.

  23. peterd
    February 1st, 2008 at 23:11 | #23

    Ian Gould wrote:
    “If I can be forgiven for answering for Terje – that’s exactly what he means.
    I have discussed this with him in the past and don’t consider it a fruitful line of conversation.”

    Thanks, Ian. I thought I’d had this conversation with Terje too, a year or so ago, and pointed out (sources cited) that I didn’t think this claim was correct. I had begun to wonder whether my memory was serving me well. Inflation had actually begun take off in the late 1960s, ahead of abolition of the gold standard.
    Cheers

  24. Ian Gould
    February 3rd, 2008 at 14:39 | #24

    It looks like Australia could be in even worse shape than the US:

    http://www.abc.net.au/news/stories/2008/02/03/2153047.htm

    “Economists predict the number of Australians likely to default on their home loans this year will increase because of rising interest rates, massive credit card debt and falling house prices.

    Research by JP Morgan and Fujitsu Consulting quoted in Fairfax publications suggests 750,000 home owners will be hit by ‘mortgage stress’ in the coming months.

    It is anticipated up to 300,000 of those will default on the loan and could have their homes repossessed.”

  25. Stephen L
    February 3rd, 2008 at 15:07 | #25

    That’s a very interesting point Ian. Colorado, another swing state slowly drifting towards the Democrats is similar.

    Comparison of Ohio and Pennsylvania should test the influence of foreclosures. For quite a few elections Ohio has given a few more percent to the Republicans than it’s very similar neighbour, usually enough to place them in opposite columns. Yet the foreclosure rates are completely different. If it has a large effect we should see far more similar results for the two this year. If one candidate can pick up both they’ve almost got the election won.

  26. Katz
    February 3rd, 2008 at 15:27 | #26

    Where credit is easy, and the consequences of non-repayment are not too drastic, households can maintain consumption for long periods even when their income is falling. So, the political resistance to pro-rich policies is much less sharp. The massive increase in income inequality in the US since 1970 has coincided with an equally massive boom in consumer credit.

    There’s a coincidence, but not a linkage.

    Both of these phenomena are products of the political process.

    The pro-debtor legislation was enacted during the liberal 1970s.

    The pro-rich tax cuts were enacted during and after the Reagan era.

    This is evidence of the phenomenon that it is often easier to pass legislation than it is to repeal it. This is because legislation often creates its own vested interests who would feel its repeal very keenly.

    Social Security is a powerful case in point in the US. Major inroads into SS entitlements would spark a rebellion in the US.

    Medibank is a case in point in Australia, and one may add a judicial system of IR to that list as well.

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