This note is in response to a comment by BCG81.
To your point here, I read recently (Mark Hanson's blog) that one of the principal unintended consequences of the state foreclosure moratoria, loan modifications and other government "keep people in their homes initiatives" has been to deprive the housing market of foreclosure sales, and thus of its main driver.
First, thanks for pointing out Mark Hanson’s blog. I read a few of the posts and the work there is quite good. I recommend the site.
It’s true that foreclosure moratoria reduce the volume of houses on the market. But is this a good or a bad thing?
Let’s focus on the income side of the household’s balance sheet. Consider a household that experiences a combination of temporary and permanent shocks to income. Without getting overly technical, think of a temporary shock as an unemployment spell followed by reentry into the same industry at the same wage and a permanent shock as an unemployment spell followed by reentry into a low wage industry.
Foreclosure policy must consider the type of shock hitting the household. If the shocks are permanent, the household entering foreclosure likely needs to move to more affordable housing. In this case, a foreclosure moratorium does nothing but slow the adjustment of the housing market. It also slows adjustment of the labor market as the household will be hesitant to give up their free housing to conduct a job search outside of their local area. With permanent shocks, foreclosure moratoria should not be used.
What about temporary shocks? It’s true; during the period of unemployment the household cannot afford their house. But the situation is temporary. In a year or possibly two years, the household will be able to afford their current house. In a frictionless market, the household should move anyway. During their period of unemployment, the household should consume less housing; just as they are likely consuming less of other goods. But the housing market is far from frictionless. A foreclosure moratorium, in this case, prevents the market from adjusting, in a good way.
So, foreclosure moratoria are good or bad depending on the nature of the shocks facing households. I think the economic situation calls for nuanced policy. In some areas, places where the downturn is clearly temporary, a foreclosure moratorium is likely helpful. In other places, Detroit, a moratorium is likely to prevent needed long-term adjustment.
On a side note, none of the moratoria that have been used to date are long enough to be helpful. Three to six months is simply not long enough to allow a reasonable adjustment. I think moratoria should be in place for at least a year to have any hope of being effective. Further, I think moratoria should be considered on a case-by-case basis rather than wholesale for entire regions. Households should justify their need. We cannot measure whether or not they have a permanent or temporary shock, lacking a crystal ball, but we can tell if they have an income shock. A household that can’t afford their mortgage with their existing mortgage needs to move on.
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Scale up the single household model of appropriateness of loan modifications & moratoria might suggest that these policies are simply postponing the inevitable. For instance, it is widely acknowledged that the financial crisis has led to a step down in total GDP, with a strong possibility of lower trend growth if deleveraging continues (as it surely must). This seems to be the total economy equivalent of a permanent loss of income for households - with the obvious conclusion that loan modifications are undermining adjustment.
I agree, a total economy loss of income. But the loss is not spread evenly. Some households are in houses they cannot afford and they should sell and move into smaller accomodation. Allowing foreclosures to move forward can facilitate this transition. However, some households experience only a temporary shock and live in a house they can afford once the shock is past. These households would benefit from a moratoria.
Blanket moratoria are likely bad. Taylored ones are probably not so bad.
I certainly agree the pain is not evenly spread. I guess its acceptable to argue ex-post about the efficiency of identifying the temporary vs. the permanent loss of income.
I don't want to sound too the-market-can-take-care-of-itself (I work there, it can't), but the distinction between temporary and permanent income shocks ought to lead a workout guy doing a decent job to give you restructurings around situations that should improve and foreclosures where that is the higher-NPV alternative. One problem I see (and Mark describes very nicely) is that for the lending that drove house prices and (I think) pretty much the rest of the economy through 2007, income just didn't matter. Nobody paid any attention to whether the borrower had enough income to repay, and making credit irrelevant to lending seems to have been the force that drove the 'evolution' of the banking/financial system. So a big - maybe the biggest - part of the problem is probably automatically (i.e., without regard to employment/wages/income) equivalent to a permanent shock. Then we have the employment effect on top of that. I tend to think that's why we ended up with the indiscriminant moratoria: if we just did the workouts one at a time (assuming the MBS servicers can do them right, not sure), the permanent losses would overwhelm the banks.
Also, do moratoria in response to temporary shocks necessarily keep the market from adjusting "in a good way"? Couldn't this build inventory, potentially increasing supply relative to demand and causing prices to fall during the time it takes to resolve the temporary shock. And depending on how you restructure the loan during this period (e.g., is interest paid? capitalized?), it may offer lenders a lower recovery than foreclosure, thus impeding the deleveraging process. But again: given how much of the shock is permanent and the govt's unwillingness to exercise greater control over banks, it's probably true that taking a bigger loss over a longer period of time is preferable to taking a smaller one all at once.
The model seems to be the LDC debt crisis of the 1980s. Personally I think this overstates the importance of the banking system (beyond its ability to clear payments and provide working capital) in an environment like this and overprioritizes it in recovery policy/strategy.
Glad you're back - I'm an avid reader, many thanks for your efforts
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