Taking a hard line on rewriting the bankruptcy code
THE AVERAGE sales price of a Massachusetts home fell 4.6 percent last year to $310,000. The state's housing market is doing well relative to California, where average prices have fallen by 26 percent. Of course, during a downturn, every dollar lost by an owner who sells is a dollar saved by a buyer. Congress should act to reduce the suffering associated with the more than 50 percent increase in the number of foreclosures last year, but legislators should avoid extreme measures, like rewriting the bankruptcy code, in a mistaken attempt to stop the natural swings of housing prices.
In places with fewer building restrictions, like Atlanta and Dallas, housing price volatility is moderated by a construction sector that supplies extra houses during booms and ratchets back building during downturns. In California and Massachusetts, where abundant land use restrictions keep new construction low, any uptick in demand translates into higher prices, which then come back to earth. If an area's prices go up by an extra $100,000 over five years, then, on average, those prices fall by an extra $32,000 over the next five years.
There are winners and losers in both booms and busts. Owners, who win during booms and lose during busts, get the most attention. We often ignore prospective home buyers, who lose just as much as owners gain during booms and gain just as much as owners lose during busts. Moreover, housing cycles don't pose huge risks to most homeowners, whose longer time horizons enable them to sit out downturns.
Housing cycles pose the most danger for deeply leveraged, short-term investors. No matter what the get-rich-quick-in-real-estate infomercials say, short-term bets on housing are a terrible, hard-to-diversify investment for the little guy. While I don't have much sympathy for speculators caught in the current housing downturn, there are plenty of homeowners who are in the same position as those speculators, despite the best of intentions. These owners got in trouble, either because their incomes fell or because their interest payments rose. Now they are looking at either foreclosure or large capital losses.
There are good and bad ways for the government to do something to help worthy, desperate owners facing foreclosure. The most honest and best way is to spend taxpayer dollars. The worst way is to change laws and regulations that don't need changing, so that money can be redistributed without raising taxes.
The current proposal for the Federal Housing Administration to increase its refinancing of troubled mortgages is an example of honest redistribution. The FHA can issue mortgages and resell them in a transparent way that aids those with the most need. Moreover, the FHA can access Social Security records so that it can avoid bailing out those borrowers who misrepresented their incomes on their mortgage applications.
By contrast, there is little to like about the proposal to give bankruptcy judges the power to rewrite mortgage terms. The relatively clear property rights facing mortgage lenders explains why interest rates on houses are so much lower than rates on credit cards. An abundance of economic data show that when you make it more difficult for lenders to collect, interest rates rise and borrowing falls.
Some bankruptcy reform advocates point to an unpublished study that claims that interest rates weren't higher 15 years ago in states where judges could cram down mortgage rates. This study surely understates the long-term effects of rewriting creditor rights, but even this work finds that interest rates were 15 basis points higher in cram down states. Fifteen basis points may not seem like much, but on $10 trillion of mortgages, this means an extra $15 billion a year in housing costs. The impact of cram down seems to have been bigger for lower risk borrowers, which suggests that bankruptcy reform will hurt the best behaved borrowers most and do little to stop speculators.
Moving from the current system to one in which hundreds of judges make up the rules for millions of mortgages is a recipe for confusion, administrative waste, and higher interest rates. Ultimately, that will make housing less affordable to ordinary Americans.
Edward L. Glaeser, a professor economics at Harvard University, is director of the Rappaport Institute for Greater Boston.
