New thinking on non-performing loans, banks and mortgages

In a new book which is bound to cause controversy, two young academics Mian and Sufi (Princeton and Chicago universities, respectively) provide new thinking and ideas on loans and mortgages. Should banks share the cost of nonperforming loans? Are austerity policies on credit leading us in the wrong direction? What brought about the current recession?

Contrary to much popular belief, the bankruptcy of Lehman Bros was not the main factor behind the 2008 recession which swept the USA and much of the rest of the world. In an analysis which may have major implications for Cyprus, the authors identify housing debt and losses associated with the collapse of house prices as a much more likely trigger for the current recession.

In the material below I only focus on the main points of the book (“Atif Mian and Amir Sufi - University of Chicago Press, 2014) regarding banks and mortgages. These fall under two main themes:

1. The problem

The present laws relating to bank credit for housing are misguided. The present system does not only carry much of the responsibility for the present economic downturn, it is also unfair to the homeowner. Under the current system a down turn in house prices may mean that homeowners, having paid their mortgage for years, may lose all of the equity in their home, as many have done. Some home owners may find that they have not only lost their equity but they now owe the bank more than the home is worth.

This is unfair to the borrower as well as counterproductive for the broader economy. As the authors point out: banks choose their debtors. They have developed systems for doing this. If they have made a mistake, why should the responsibility for this fall entirely on the borrower? It would be fairer and economically more constructive if losses and gains due to changes in house prices were shared.

2. Proposed solution

The authors advocate “shared responsibility mortgages” (SRMs). These have a resemblance to equity. They are “equity like” and act as a counter to the sort of housing related business cycle we have been experiencing. On the down part of the cycle, losses due to changes in house prices are shared with the bank.

The proposed SRM is connected to a house price index. If the price of a house (according to the index) falls below the purchase price, the previously agreed mortgage interest payment would also drop. The payment schedule remains the same but the amount due is now less (the mortgage interest payment reducing in proportion to the drop in house prices). If the owner keeps the house until the full term of the mortgage, he/she would have paid less than the initially agreed mortgage.

If the drop in house prices persists, the owner of the house would also suffer a drop in the equity held in the value of the house. But, unlike the present scheme, the owner would still retain some equity in the house, the amount depending on the size of the drop in the house price index.

If, after having fallen, the price index rises, the system goes into reverse and the home owners’ mortgage payments would rise in line with the index.

COMPENSATING THE BANKS

Under this system the lenders (banks) incur greater risk, for which they should be compensated. There are two possible ways to provide this extra compensation.

(a) The authors estimate that (based on USA data) the lender could be compensated by an additional charge equal to “1.4% of the initial mortgage amount”, or,

(b) This extra charge could be eliminated by an agreement giving the lender a small share in the upside of any capital gain when the seller refinances or sells the house. This is estimated (using data on USA historical house prices) at 5% of any capital gain.

The above is only a briefest outline of some of the book’s main points. They are clearly controversial as well as timely and innovative.