Posted by Eric Posner:
Chapter 13 reform: the Zingales plan
http://volokh.com/archives/archive_2009_01_18-2009_01_24.shtml#1232638414
In my last [1]post, I described Durbin�s bill for reforming Chapter
13. Luis Zingales, a professor at the business school of the
University of Chicago, has made the following [2]proposal, which can
be treated as an alternative to Durbin�s approach.
Congress should pass a law that makes a re-contracting option
available to all homeowners living in a zip code where house prices
dropped by more than 20% since the time they bought their property.
Why? Because there is no reason to give a break to inhabitants of
Charlotte, North Carolina, where house prices have risen 4% in the
last two years.
How do we implement this? Thanks to two brilliant economists, Chip
Case and Robert Shiller, we have reliable measures of house price
changes at the zip code level. Thus, by using this real estate
index, the re-contracting option will reduce the face value of the
mortgage (and the corresponding interest payments) by the same
percentage by which house prices have declined since the homeowner
bought (or refinanced) his property��.
In exchange, however, the mortgage holder will receive some of the
equity value of the house at the time it is sold. Until then, the
homeowners will behave as if they own 100% of it. It is only at the
time of sale that 50% of the difference between the selling price
and the new value of the mortgage will be paid back to the mortgage
holder.
Zingales�s plan would help mitigate the three difficulties I
identified before.
First, the entire Chapter 13 bankruptcy process, with its costs and
delays, would be avoided. Rather than renegotiating the mortgage, in a
process that involves the debtor, the judge, the loan servicer, and
perhaps others, the mortgage is simply revised �automatically��though
presumably some public official would need to be involved.
Second, the use of housing prices by zip code as a proxy for distress
reduces the risk of opportunism by debtors, although it does not
eliminate it completely. It nicely captures the problem, which is one
of contagion. The implicit assumption is that loss of value of a house
as a result of foreclosure is likely to be greater if neighboring
houses are also being foreclosed than if the neighborhood is stable.
Third, giving the mortgage holder(s) equity in the house should reduce
the incentive of debtors to use the plan opportunistically, since they
will only enjoy part of the upside if housing prices recover;
therefore, the plan should have less of a detrimental effect on the
cost of credit going forward.
This debt-for-equity swap is the most interesting element of
Zingales�s plan. In Chapter 11 reorganizations, debt-for-equity is
standard operating procedure: equity is wiped out and debtors� claims
are converted into equity interests. Zingales implicitly proposes to
transfer this approach to Chapter 13.
Unfortunately, there are some serious grounds for skepticism. Zingales
points out that it is not unknown for third parties to have equity
interests in houses�universities sometimes provide housing support to
faculty in this way (I suspect, however, for tax reasons). But if it
were such a great idea, it would be a lot more common.
Consider how this might work. Suppose you are a first-time home buyer,
and you would like to buy a $200,000 house. Your bank offers you a
$160,000 mortgage, so you must come up with $40,000 as your down
payment, which will be your equity. Suppose you say to your neighbor,
or some other financial institution, �if you give me $20,000, I will
give you a 50% equity stake in my house.� Any takers? An equity
interest in someone else�s house is surely a bad investment. You have
no idea what that person is doing with his house and you have no
control over it even if you do (unless you demand voting rights ��).
Meanwhile, the other person has distorted incentives: at the margin,
he�ll put money in the house that improves its idiosyncratic value for
him rather than money that improves its resale value. These equity
interests would not be very liquid, either.
So I can imagine very easily mortgage holders saying �no thanks� to
the equity interest (indeed, the law would need to be changed to allow
banks to accept an equity interest, and think what those interests
would do to their balance sheets!). And if you think it is hard to
value a MBS now, imagine what it would be like if each security gives
you a right not only to a slice of principal and interest but also to
some impossible-to-determine upside. (They will be worth more,
however, under Zingales� plan.) I suspect that government-supplied
mortgage assistance would be more straightforward and efficient. The
Chapter 11 setting is different; there, trade creditors who unhappily
end up with some equity shares can sell them immediately to people who
are in a position to monitor the firm.
The plan would also probably be hard to swallow, politically. Suppose
I have a mortgage of $380,000 and a house worth $280,000 and that
houses in my zip code declined by 50 percent. Hence, my new mortgage
would be $190,000. If I immediately sold my house, I would get to keep
half of the equity, that is, one half of $90,000 or $45,000. The
mortgage holder would receive $190,000+$45,000 = $235,000, which is
$145,000 less than the original mortgage. To be sure, that is more
than the post-foreclosure value of the house ($140,000). The whole
idea is to avoid foreclosure with the result that a surplus is
created, which is divided between the debtor and creditor�the essence
of renegotiation. But I think it would be hard for people to stomach
homeowners, especially �flippers,� walking away with a big profit.
Still, the idea is clever, and perhaps some variant would be more
plausible. What do readers think? Can it be improved?
References
1. http://volokh.com/posts/1232596135.shtml
2. http://faculty.chicagogsb.edu/luigi.zingales/research/PSpapers/plan_b.pdf
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