Charles Calomiris has an editorial in the FT calling for lower loan-to-value (LTV), Time to introduce minimum downpayments for mortgages:
Without high leverage the subprime boom and bust could not have happened. Risky no-docs borrowers would have been unwilling to deceive lenders if they had to pledge a large amount of their own savings as a downpayment (deposit). House price declines would not have produced huge loan losses if homeowners had retained a minimum 20 per cent stake in their homes.
During the 1990s and 2000s leverage tolerances on US government-guaranteed mortgages rose steadily and dramatically at FHA, Fannie Mae and Freddie Mac. The average loan-to-value (LTV) ratio of FHA mortgages rose to 96 per cent, and a third of Fannie and Freddie’s purchases leading up to their insolvencies had LTVs of greater than 95 per cent.
Not only are high LTVs destabilising, they undermine the objectives of housing policy. Its central goal is promoting stronger communities by encouraging residents to have a stake in them. But a 97 per cent LTV creates a trivial stake; homeowners become renters in disguise, able to abandon homes at little cost.
This is very sober, reasonable and responsible. It makes you wonder why did we ever deviate from it in the first place. Alyssa Katz has written convincingly that simple rules on HLTV and using your home as a credit card helped protect Texas from a housing bubble. What kind of person would think letting people have incredibly high LTV (HLTV) was some sort of cure?
Here’s the very same Charles Calomiris (along with Joseph R. Mason), at the conservative think-tank American Enterprise Institute back in 1999, with High Loan-to-Value Mortgage Lending: Problem or Cure?
SPOILER ALERT! Calomiris thinks it is the cure.
Instead of congressional Democrats or community organizers or ACORN, if you were worried about High LTV lending taking over the mortgage market you would have to have tackled AEI and Calomiris, who put their full intellectual energy and credibility behind the scheme.
(I find it ironic that all these right-wing think tanks have a level of tenure and a socialistic safety net that would make teacher unions and Scandinavian countries jealous. Think if the level of the wrongness of this paper was done by someone working at McDonalds! It is just impossible to flunk out….)
The whole thing is a treat of what the punchbowl looked like at the turn of the century, and I recommend checking it out. Let’s go over some of my favorite things from that paper, with the last one being very relevant for our current crisis. Charles (my bold):
“Not only do HLTV borrowers and lenders gain from reduced default risk, but the economy as a whole is more stable as the result of HLTV lending. Enhanced con- sumer liquidity and reduced consumer default risk stabi- lize aggregate demand. Moreover, because HLTV lending can rely on securitization for the bulk of its financing (see chapter 4), it provides a more diversified, and thus a more stable, source of consumer credit.
High loan-to-value lending is a fast-growing sector of the mortgage industry that has evolved to meet the needs of today’s consumers and to compensate for the deficiencies of consumer bankruptcy law. HLTV lending allows consumers to commit credibly and voluntarily to not defaulting on consumer debt, and thus to use their home equity to reduce their debt service costs and to insulate consumption from temporary fluctuations in income. Because the industry has expanded quickly—and competition has become fierce—some underwriting standards have been questioned. But lenders realize that the securitization that provides their funding base opens the industry to constant and detailed market scrutiny and discipline, and they have responded to that discipline by maintaining conservative lending standards, including high minimum credit scores and tight underwriting and monitoring guidelines.”
High LTV means the economy is more stable. Check. I think we are all familiar enough with the financial crisis to know how much misery and disaster came from the assumptions in the last bold text, the assumptions that the servicers and the private securitization mechanism would magically work itself out.
But I’m interested in the party about how having a very high LTV and using housing equity as a credit card allows consumers to “insulate consumption from temporary fluctuations in income.” Because, as millions of Americans are finding out as they can’t make their mortgage payments, you can’t make partial payments or revolve mortgage debt. To collapse the distinctions between credit card debt and mortgage debt turned out to be a bad call.
“Consumers are less likely to choose high debt levels when default would place their homes at risk.”
Isn’t it now considered more likely?
“Is there is a dark side to securitization? Might securitization expose consumer financing costs to a new risk—the possibility that funding might be withdrawn suddenly from the market? The possibility of a significant interruption is remote.”
A “shadow banking run” is a remote possibility. The shadow banking market didn’t even make it 10 years after this line was written.
“Some skeptics maintain that HLTV borrowers start out looking sound but are prone to subprime default characteristics later because of poor credit habits and the high LTV leverage. Although the HLTV market has not yet been tested through a cyclical downturn, this assess- ment is questionable.”
Blurring the Lines in Bankruptcy to Save Pennies
So what’s the advantage of doing things this way? This is crux of his argument: the fact that junior liens confuse ownership and create extra burdens and conflicts in bankruptcy is the selling point. Junior liens are willing to extend credit cheaper because they can’t be written down in bankruptcy. Ladies and gentlemen, the cramdown debate in 1999 (see how everyone knew this was coming!):
“Misplaced concerns about the riskiness of HLTV lending and the destabilizing effects of reloading and churning have led some in Congress to advocate altering personal bankruptcy law to allow cram-down—or bifur- cation—of mortgage debt exceeding 100 percent of home value. Under such a scenario a borrower filing under Chapter 13 would avoid foreclosure. Mortgage lenders would retain senior claims on the borrower up to the amount of the fair market value of the underlying property at the time of bankruptcy. The HLTV loan would thus be second in line as a claim on borrower wealth up to a maximum of the value of the mortgaged property. The amount of the HLTV loan greater than the value of the underlying property at the time of bank ruptcy would be treated as unsecured debt and placed on an equal footing in the bankruptcy process with other unsecured debt.
Such a fundamental change in the nature of the HLTV debt contract would undoubtedly undermine the special advantages of HLTV loans. By limiting the re- sources that stand behind the loan to the value of the mortgaged property itself, the law would transform HLTV lending from its current form—a relatively sen- ior, collateralized claim on the consumer’s wealth—to es- sentially a junior claim on the amount of housing wealth (but not the actual house) of the consumer….
Cram-down would essentially eliminate that special bargaining power of the HLTV lender.”
That “special bargaining power” is what is keeping the mortgage market from clearing for the next several years. Servicers both are more than happy to rake in huge fees playing these lenders off each other as well as have huge liabilities in what they can actually legally do in terms of negotiating these leins.
From Calomiris’ point-of-view, this is the feature, not a bug. The huge conflict, uncertainty and confusion in having multiple liens is what allowed people to use their homes as an ATM for a few percent points cheaper. By adding confusion to the order of claimants in a bankruptcy court and the ability to re-negotiate and letting the mortgage market as a whole leverage up everyone got to spend at the mall a little cheaper at the margins.
Meanwhile the four largest banks have half-a-trillion dollars worth of juniors they have no idea how to value and we’ll sit and wait to see what happens. Just don’t try and sell your home if you had a reasonable LTV for the next few years.
The libertarian writer Megan McArdle has been writing about how the second mortgages are really causing problems in getting the mortgage market to clear; thank god she is saying that now instead of 1999, when she might have been expelled from the movement….