Smaller Mortgage, But Full Recourse

If you haven’t been paying attention, the administration has tacitly adopted a Japan-style, “muddle through” strategy to deal with the housing (and banking) bust.

Namely, instead of forcing banks to take massive write-downs and pushing for regulatory overhaul, the government has ushered in an era of super-cheap money (at least for banks) that gooses bank profits and slowly nurses them back to health.

In fact, bank earnings are up dramatically. Even the banks thought to be sickest, like Citigroup and Bank of America, are now reporting billions in quarterly profits.

So what’s the problem?

A weak economy is creating millions of additional foreclosures, which is putting renewed pressure on home prices, which in turn is undermining the banks’ recovery:

Despite a slight uptick in house prices in some markets recently, the sales of foreclosed properties continue to dampen house prices and weaken banks’ balance sheets. The uncertain pace of future losses makes banks nervous about the adequacy of their capital, which discourages bank lending and economic growth.

–Martin Feldstein, “How to Save an “Underwater’ Mortgage“; The Wall Street Journal (8/8/09)

Feldstein’s prescription?

Take the pressure off both underwater homeowners and ailing banks by striking a quid pro quo: reduce the balance of the mortgage borrowers owe, but in return, make the rest full recourse (now, mortgages are non-recourse). To make such “medicine” easier for the banks to swallow, the government would reimburse the bank for part of the write-off.

Here’s how it would work (Feldstein again):

Consider someone with a home worth $200,000 and a mortgage of $280,000, i.e., a loan-to-value ratio of 140%. If the borrower and the creditor both agree, the loan could be reduced by $40,000 to $240,000 (120% of the home value.) The government would give the creditor $20,000 to offset half of the write-down. The homeowner would convert the remaining $240,000 mortgage to a bank loan with full recourse that could not be discharged in bankruptcy. The bank takes a $20,000 loss (as part of the $40,000 mortgage write-down). But it would be better off, because it has a more legally secure loan of $240,000. The homeowner owes less, but he is now personally responsible to repay the loan in full.

Makes sense to me.

However, the catch with all such “rational” solutions to the housing mess — and there have now been several — seems to be getting the banks to sign on.

About the author

Ross Kaplan has 19+ years experience selling real estate all over the Twin Cities. He is also a 12-time consecutive "Super Real Estate Agent," as determined by Mpls. - St. Paul Magazine and Twin Cities Business Magazine. Prior to becoming a Realtor, Ross was an attorney (corporate law), CPA, and entrepreneur. He holds an economics degree from Stanford.

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