The More You Borrow, the Less You Will Pay

Filed Under (Finance, U.S. Fiscal Policy) by Nolan Miller on Aug 19, 2010

I saw an interesting piece in the New York Times entitled “Debts Rise, and Go Unpaid, as Bust Erodes Home Equity.”  Home equity loans are secured against homeowners’ equity in their homes.   During the housing boom, it was not uncommon for a homeowner to buy a home for, say, $100,000, watch its “value” increase to $200,000, and then take out a loan secured against this increase in the value of the home.  Just by riding housing values up, this homeowner could gain access to a line of credit of up to $100,000.

If housing values continue to rise and people keep working, everybody is happy.  Homeowners can make relatively small payments on the home equity loan and enjoy increased consumption in the short run.  Eventually, when they sell their house at a higher price, they can pay off the loan and everyone wins. 

However, in the face of a national recession and housing bust like we’ve experienced lately, things look quite different.    People have lost their jobs, and so can no longer afford to make their loan payments.   In ordinary times, the lender would seize the collateral for the loan – in this case the house.  However, at the same time we’ve been going through a recession, we’ve also been experiencing a housing bust.  So, the house that had been valued at $200,000 at the time the loan was written may not only be worth $80,000.  The collateral is no longer there.

The result of this dynamic is an increase in defaults on home equity loans.  Faced with financial difficulty, buyers are choosing not to pay their home equity loans and challenging the banks to try and collect.  However, in the case of home equity loans, this can be particularly difficult for banks, since, following bankruptcy, home equity loans are paid off only after primary mortgages.  So, if an equity lender tries to collect, the borrower can simply threaten bankruptcy, in which case the equity lender will most likely get nothing.  Thus, rather than being at the mercy of the banks, households that took out large amounts of debt are actually in a position of power.  To quote a couple of paragraphs from the article:

The result is one of the paradoxes of the recession: the more money you borrowed, the less likely you will have to pay up.

“When houses were doubling in value, mom and pop making $80,000 a year were taking out $300,000 home equity loans for new cars and boats,” said Christopher A. Combs, a real estate lawyer here, where the problem is especially pronounced. “Their chances are pretty good of walking away and not having the bank collect.”

Even when a lender forces a borrower to settle through legal action, it can rarely extract more than 10 cents on the dollar. “People got 90 cents for free,” Mr. Combs said. “It rewards immorality, to some extent.”

This phenomenon points toward an interesting change in American culture that reminds me of a story from my own life.  When I was in graduate school, I would rent movies from Blockbuster Video. (This was pre-Netflix, but at least they were DVD’s!)  I used to take the due dates very seriously, to the point where I’d pull on my shoes and run out at 11pm just to return a movie before the midnight deadline.  Then, one day, I didn’t, and I realized that nothing bad happened to me if I did.  Sure, there was a fine, but it was one I could deal with.  From that day on, I don’t think I ever returned another video on time.

What we’ve been experiencing lately with regard to bankruptcy and loan delinquency is much the same.  There hasn’t been a change in bankruptcy policy.  And, while there has been a change in economic circumstances (some responsible people can’t afford to repay reasonable loans that were taken out in better times), there has also been a cultural change whereby declaring bankruptcy is no longer seen as a last resort.  It has become acceptable to declare bankruptcy strategically, even before all available options for repaying as much of a loan as possible have been exhausted.  And, lenders are now aware of this.

It is difficult to know the impact of this change on lending markets, but it is likely to be profound.  Home equity loans, which used to be straightforward, are likely to be more difficult to acquire, as lenders begin to protect themselves against the possibility of a housing downturn in a world where people feel it is acceptable to walk away from their obligations.  These protections will likely involve fewer loans, smaller loans, higher interest rates and stronger collateral requirements.

An Idea for Safeguarding Pensioners and Taxpayers

Filed Under (Retirement Policy) by Jeffrey Brown on Dec 10, 2009

In at least one previous post, as well as in other research papers and articles, I have discussed the enormous problems facing the Pension Benefit Guarantee Corporation (PBGC), the government corporation that insures private defined benefit pension plans.  This week, a very talented MBA student at Illinois – Gagan Bhatia – reminded me of a terrific idea that would go a very long way toward providing plan sponsors with economically appropriate incentives for funding their plans.  Right now, plan sponsors lack appropriate and sufficient incentives to fully fund their plan or to choose a portfolio that immunizes the plan funding from market risk.  Sure, the government imposes funding requirements, but they have proven woefully inadequate.

In fairness, while Gagan Bhatia came up with this idea on his own and independently, it is an idea that has been out there, including in some work by Doug Elliot of the Center on Federal Financial Institutions.  Regardless of who gets credit, I think it is a terrific idea.

In a nutshell, the idea is to increase the seniority of pension claims in the event of a bankruptcy.  When a company files for Chapter 11 bankruptcy, the company’s creditors and claimants fall into different pools as per their priority over the company’s assets. PBGC’s obligations fall into the Unsecured Creditors pool which are paid after the Secured Creditors.   

Under this proposal, the PBGC would be moved up the line and be considered a senior, secured claim.  In essence, it would allow the PBGC to get paid first (or at least earlier than under current law) from any assets that the plan sponsor has remaining.

Why does this help?  Currently, creditors have insufficient incentive to consider the funding status of a firm’s pension plan when the firm is issuing debt.  If creditors knew that the PBGC’s claim on the firm’s assets was senior to that of the creditors, then creditors and potential creditors would become powerful enforcers of economically appropriate funding behavior.  Plan sponsors that failed to adequately fund their pension or plan sponsors who failed to engage in asset-liability matching would be considered – appropriately – to be a higher credit risk.  Thus, the firm would have to pay more to borrow.  Firms that funded their pensions and invested them in a manner that mitigated future funding risk would benefit from lower borrowing rates. 

In essence, this approach would harness market forces to achieve a worthwhile public policy goal.  Along the way, both pensioners and taxpayers would benefit.