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Recourse, Of Course—A Commentary by Ian Ayres ’86

The following commentary was published in The New York Times on November 25, 2008.

Recourse, Of Course
By Ian Ayres ’86

Martin Feldstein has written another Wall Street Journal op-ed (here’s an NBER version) extending his idea for stabilizing home prices. Steven Levitt has written about Feldstein’s basic idea before. The basic idea is for the government to provide low-interest loans to mortgage holders in return for mortgage debt:

The federal government would offer any homeowner with a mortgage an opportunity to replace 20 percent of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. This would be available to new buyers as well as those with mortgages. The interest on that loan would reflect the government’s cost of funds and could be as low as 2 percent.

The Feldstein proposal has a real advantage relative to Luigi Zingales’s ingenious “Plan B.”

Zingales proposes that Congress pass a law to give a recontracting option to all homeowners living in a zip code where housing prices have dropped by more than 20 percent. If exercised, the Plan B option will write down the face value of the mortgage by the same percentage that the area housing price has dropped and, in return, the homeowner will give the mortgage holder 50 percent of any appreciation at time of sale. (Zingales points out that mortgage holders will do much better under this program than with foreclosures, where transaction costs eat up a hefty proportion of the market value.)

Feldstein, like Zingales, reduces the incentives for homeowners to default on their mortgages. But Feldstein avoids the sticky question of bank approval. Zingales’s plan tries to do this by legislative fiat. But a law that forces mortgage holders to accept a write-down of principle might violate the Constitution’s Takings Clause. Indeed, another parallel between 1932 and 2008 may be how the court responds to legislative innovation. (Here, Chief Justice Roberts plays the role of Charles Evans Hughes.)

But the Feldstein proposal has a couple of real disadvantages as well. Feldstein emphasizes that the government loan would be a “recourse” loan, giving the government the right to look to homeowners’ wages and other assets. Feldstein is critical of American exceptionalism with regard to making mortgages non-recourse:

The “no recourse” mortgage is virtually unique to the United States. That’s why falling house prices in Europe do not trigger defaults, since the creditors’ potential to go beyond the house to other assets or to a portion of payroll earnings is enough to deter defaults. Officials and investors in other countries are amazed to learn that U.S. mortgages are no recourse loans. It is indeed surprising that this rule in the U.S. applies to home mortgages but not to any other type of loan.

Feldstein’s proposal, however, goes beyond merely making the government loan “recourse.” Feldstein would not make the loan eligible for relief in bankruptcy.

To me, it’s an open question whether many homeowners would accept the bribe of a subsidized write-down in third-party mortgages in exchange for taking on a recourse, no-bankruptcy loan. In scary economic times, many homeowners might be reluctant to take the Feldstein option.

The big concern is that we still may be on the brink of an even larger foreclosure disaster — with wave upon wave of foreclosures feeding back to reduce housing prices, thereby inducing more homeowners to walk away from their mortgages.

To stabilize things, we need to solve what economists call a “participation constraint” problem. We need to either 1) meet homeowners’ participation constraint (offer them a deal that is worth taking), 2) meet mortgage holders’ participation constraint (hard to do because ownership is so fractionated), or 3) take on the hard question of cramming down a legislative solution that roughly makes the different participants better off.