A million foreclosures

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.

26 thoughts on “A million foreclosures

  1. 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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