The Washington Post had an editorial today in which came out squarely against using taxpayer dollars to “rescue” the housing market. Of course its rationale is not exactly right – these bailouts are far more about helping banks and investors than homeowners, but the Post still ends up in the right place. The editorial is out of whack in that it seems to have bought the mortgage industry’s line that allowing bankruptcy judges to change the terms of mortgage contracts would lead to some huge increase in the cost of mortgages. It just takes some simple arithmetic to realize that this assertion is nonsense. In normal times (i.e. when we are not in the middle of the crash of a housing bubble), loss rates on home mortgages are very low. Even averaging in recessions, we would probably only get a loss rate in the neighborhood of 0.16 percent annually. Most of the losses on mortgages are not the result of houses that pass through bankruptcy process. People simply default on their mortgages and let the banks take possession. Let’s be generous and say that half of the losses, an amount equal to 0.08 percent of mortgage debt, result from mortgages that pass through the bankruptcy process. (The share could rise a bit from current levels, if the bankruptcy law is changed.) Now suppose that bankruptcy judges alter the terms of mortgages so that the losses on these mortgages increase by 25 percent (this would be huge). That would mean an increase in the losses to the banks equal to 0.02 percent of all mortgage debt. If we throw in an extra 0.01 percentage points (50 percent of their extra loses) to cover their additional risk, we get an increase in lending costs of 0.03 percentage points as a result of allowing bankruptcy judges to alter home mortgages. An increase in the average mortgage interest rate of 0.03 percentage points is not altogether trivial but it is hardly disastrous as the Post editorial implies. This will not shut down the mortgage industry or even have a substantial impact on home buying. Of course, if we want to reduce the impact of this measure even further, we can make it time limited (recognizing that we face very unusual circumstances) so that the change in the bankruptcy rules only applies to mortgages that were issued prior to July 1, 2007, or some other recent date in the past. This may still lead to some modest hike in mortgage interest rates (we could face unusual circumstances in the future too), but an increase of 0.01 percentage point in mortgage rates would be a small price to pay to allow hundreds of thousands of people to keep their homes.
--Dean Baker
