Opinion

Felix Salmon

The upside of mortgage default

By Felix Salmon
June 2, 2010

I talked about “Jingle Mail 2.0” on Tech Ticker this morning, and Henry Blodget made the good point that freeing up mortgage payments for small-business operating expenses or consumer goods does provide a short-term boost to the economy — at the expense, of course, of banks’ balance sheets.

I’d be interested to see a economic take on this. In theory, the economy should be better off when you’re spending your money on mortgage repayments, because those repayments go straight into bank equity, which can then get levered 10X in the form of new bank loans. Similarly, if you stop making your mortgage repayments, the write-down at your bank can be enormous, and comes out of that bank’s equity, and therefore provides a significant constraint on that bank’s ability to make new loans.

But in the real world, things don’t seem to be working like that. The banks seem to be making good money while being very parsimonious in terms of new lending: all indications are that they are hoarding equity no matter what their customers do. Meanwhile, the money which would otherwise go to mortgage payments has very high utility and velocity: it keeps the employees of small businesses in their jobs, it gets spent at local businesses, and it can transform people’s lives.

And if the banks do end up in another solvency mess as a result of all this? Well, they seem to be good at raising new equity these days, and if that doesn’t work then maybe they can put together some kind of a debt-for-equity swap. So long as their cashflows are strong, a bit more deleveraging in the financial sector would probably do little harm, and might in fact improve systemic robustness.

I wonder though what would happen to mortgage lending over the long term. Right now it’s almost all being underwritten by the government, in one form or another — Fannie Mae, Freddie Mac, FHA, etc. At some point, banks are going to have to step in and take over that business. But when and how will that happen, if borrowers are significantly more willing to default than they ever have been in the past?

Comments
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This is what you get when captive administrations and congresses extend taxpayers’ credit to a few large banks for ‘extend and pretend.’ Redirect much of that credit to those of the smaller banks which are solvent when marked to market.

Posted by walt9316 | Report as abusive
 

The government has poured $145B down the rathole of Fannie and Freddie with no end in sight, and not even a patina of an exit strategy.

My sense is this is completely unsustainable over the long term, that what seemed a laudable goal of “increasing homeownership” is a burden to the undercapitalized homeowners, and now the government.

To my mind, this open ended commitment to backstopping Fannie and Freddie is not unlike the Afghanistan or Iraq wars, except at least in those there’s a loosely held plan to get out of it at some point.

Posted by corcoran310 | Report as abusive
 

The economics seem to be a bit more complicated.

First, large banks have access to equity capital but smaller community banks do not. And equity capital is especially scarce in the “sand states” which have the highest SFR delinquency rates. So large scale “jingle mail,” SFR or otherwise, will further reduce currently irreplaceable equity of community banks, causing more failures. And reducing the number of community banks will incentivize an increasing industry consolidation and oligopoly. Is it good public policy or good economics to have an increasingly concentrated financial system? Haven’t we seen some of the clear economic externalities of oligopolistic banking?

As an aside, every community bank that can’t replace its capital and fails does so at a significant cost to the FDIC fund (about 30% of total assets with the old loss share agreements and 15% with the new loss share agreements). Many of the failed bank buyers are either larger banks (City National, TD Bank) or backed by private equity (BankUnited, Premier American); buyers of failed banks have generally gotten a 30%+ return. So widespread “jingle mail” effectively promotes a transfer, via the FDIC resolution system, from the overall banking system (and their FDIC premiums) to these many times large, foreign or formerly non-bank players.

More important, I think are two other issues. First, when someone stops paying their mortgage,they also typically stop paying their taxes and insurance. And, from experience, not many of these homeowners funnel the payments into their businesses, because they are unemployed, have no businesses, they consumed the money or more likely, they paid their attorneys to keep them in the property. Is this good for the economy, for state governments or for asset values, expecially where unemployment is high or in hurricane/tornado/other natural disaster states? Second, as Akerlof and Shiller point out in Animal Spirits, much like the well-known “money multiplier effect,” there seems to be a “corruption multiplier effect:” if I don’t pay, then when my neighbors see this, then they don’t pay either, and then the next block sees us not paying and follows us, ad infinitum, until no one is paying and contractual obligations are viewed as optional. And the result is the sales pitch of countless lawyer and law firm ads on TV in the wee hours of a Florida or Arizona morning. They are on the cash receiving end of a “jingle mail.”

When this happens, what bank in their right mind would lend anyone any money to buy a house? Especially with a clogged foreclosure court system and other government disincentives to foreclose. And the result is that 98% of all SFR lending is now done with GSE involvement.

Posted by AABender1 | Report as abusive
 

Banking reserve requirements in the US are not a serious binding constraint on banks. They only have to have the proper reserves a few days (one?) a month when they are checked and can borrow them as needed. As such, a dollar of falling reserves does not directly cause the loss of $10 in lending.

Posted by OneEyedMan | Report as abusive
 

It appears that the banks are taking the hit to their bottom line that they have resisted – the loss in value of the homes that they hold the mortgage on. Bank managers didn’t want to show the loss on their watch, but now despite their best efforts the losses are showing up each month in reduced income making it harder to avoid booking the problem. What had been unrealized under collateralized mortgages are now non-performing loans.

Posted by bklynwatch | Report as abusive
 

How much of that “equity hoarding” do you suppose is precautionary, and how much do you suppose indicates that banks think their balance sheets are in worse shape in an economic sense than in an accounting sense?

Posted by dWj | Report as abusive
 

The upside of mortgage default is higher prices. Mortgage risk is being massively underpriced, still. With a less than 5% note rate, the risk premium is way too low.

Posted by Samiamy | Report as abusive
 

Felix wrote:Meanwhile, the money which would otherwise go to mortgage payments has very high utility and velocity: it keeps the employees of small businesses in their jobs, it gets spent at local businesses, and it can transform people’s lives.It can also get spent on cheap plastic short-duration consumer goods at Wall Mart, which most people don’t need and are too stupid to realize they shouldn’t want. Goods which are largely made in China and contribute to the U.S. trade deficit.

Given a choice between those two, I’d prefer borrowers give the money to the banks and fulfill their contractual obligations, reducing the potential for the banks to extract even more money from U.S. taxpayers in general.

Posted by Strych09 | Report as abusive
 

As long as banks get bailed out for the sticker price of idiotic loans they made or in many cases, made up out of thin air, they have absolutely no incentive to do anything other than play the victim scrounging for the next government handout. Clearly, handing them a king’s ransom for doing stupid things in the past hasn’t helped them see the light. They’re not in it for the broader economy, only for the amphetamine rush of funny money.

It’s completely wrong for FHA, F-Mae and F-Mac to reward banks for the shady loans they made at full pop, so expect no sanity from that quarter. What needs to happen to the institutional accomplices of bad banking is more like what happens to traitors in times of (economic) war.

You know banks haven’t got the slightest compunction when it comes to taking cash indirectly out of the public’s pocket, even from large tracts of the public that never directly owed them a brass farthing. They’re all take and no give, most major banks are.

So who actually needs banks like the ones we have here in America? Nobody. And who should feel sorry for them when they claim hardship after years of giving not a whit for you or your legitimate business priorities? Dunno about you, but I don’t. Will they change by themselves? [just kidding, of course not]

When it comes to mercy for zombie banks – and until proven innocent, they all are now – sorry, but I’m fresh out. Anybody needs to walk on a mortgage, should. It’s only business.

Posted by HBC | Report as abusive
 

What ever happened to “render unto Caeser”? Anyone capable of paying their bills should do so – for those who cannot for GOOD reason the creditors should assist in any way they can. I do personally believe that in the case of homes they should be re-appraised for a fair price and the homeowner should be permitted to refinance based on the new value of the home. At least that way people wanting to sell and purchase something else would be able to do so without suffering a huge loss on their existing home.

Posted by kschoon | Report as abusive
 

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