Robert Shiller’s book Irrational Exuberance was a watershed work in behavioral economics. When I first read it, the housing bubble suddenly made sense to me. Much of what I believe I know about financial markets, human behavior, and the housing bubble is built upon his work. He is one of my heroes.
And he has completely lost his mind.
For all his brilliance, Robert Shiller is not noted for coming up with insightful policies based in his understanding of behavioral economics. Irrational Exuberance contained no policy recommendations, and his book, The Subprime Solution, was criticized as fanciful and unrealistic. His latest editorial in the New York Times is so ridiculous, I am shocked he put it in the public view.
IMAGINE that you are watching an outdoor theater production while sitting on the grass. You have difficulty seeing, so you prop yourself up on your knees. Soon everyone behind you does the same. Eventually, most people are kneeling or standing, yet they are less comfortable than they were before and have no better view. Everyone should sit down, and everyone knows it, but no one does.
This is a collective action problem, a phenomenon that is, unfortunately, all too common. At the moment, the trouble in our real estate markets and the drag these markets are placing on our entire economy may be understood as a collective action problem. In a nutshell, mortgage lenders need to write down the amounts owed by individual homeowners — that is, let everyone sit down and relax — but the different stakeholders have been unable to reach an agreement, even if it is in their common interest.
Yes, mortgage lenders need to write down the amounts owed by delinquent loan owners, but they don’t need to give them the house in the process. Lenders need to foreclose on delinquent borrowers and get them out of the property so a borrower ready, willing, and able to make the payments can live in the house. Why does his solution need to keep the undeserving in the houses rightfully belonging to others?
The last thing we need is to write down the mortgages of all underwater loan owners to fair market value and give them a pass. What about all the HELOC abusers? Do we really want to give them trillions in free money? That is the ultimate extreme of moral hazard. Who would ever borrow responsibly again in the future? Wouldn’t everyone keep their HELOCs maxed hoping for another crash so taxpayers could pay them off?
Plus, this is not for the collective good. This is for the good of a few loan owners. Perhaps some homeowners might benefit from higher house prices, but how much do they need to pay for the bailout to get this benefit? Renters get no benefit at all, and future homebuyers get screwed.
What about all the investors who will lose money in the deal? What about the pensioners who bought mortgage-backed securities for the cashflow in their retirement. We are supposed to screw them to save HELOC abusers and loan owners?
Oh, wait. are we supposed to make the taxpayer cover the losses? Or should we just print the money? WTF is he thinking?
In the 1971 book “The Logic of Collective Action: Public Goods and the Theory of Groups,” the economist Mancur Olson argued that collective action problems are pervasive, plaguing nations and economic groups alike. “Most groups cannot provide themselves with optimal amounts of a collective good,” he said, because they cannot manage a “selective incentive” or arrange “coercion or some reward.”
In the current real estate market, the relevant group is enormous and complex. It includes those who own first and second mortgages or home equity lines of credit or residential mortgage-backed securities or the various tranches of mortgage collateralized debt obligations or shares in banks and finance companies that in turn own mortgages. These people live all over the world and have no way of communicating with each other, let alone coming to an agreement to give homeowners a break.
And you know what? They don’t want to give loan owners a break. They want to get their money back plus interest per the contract they signed with the loan owner. They either want their money back, or they want the property back. There is no other option.
My colleague Karl Case and I showed in 1996 that when the value of a home falls below the value of the mortgage debt — when it is underwater — a person is much more likely to default on the mortgage. And it is well known that in foreclosures, lenders lose so much on the legal costs and depressed market values of the homes that it would be in their interest to lower mortgage balances so the homeowners stay in place and don’t default.
No it is not in their interest to write down these mortgages. First, it creates moral hazard because everyone will expect this free money, and next time they will do whatever it takes to get it. But more importantly, only a small fraction of loan owners actually will default or go into foreclosure. To write down the mortgages on all the underwater borrowers would be much, much more costly that foreclosing on those who actually do default.
If such mortgage principal reductions could be applied on a large scale, there could be large neighborhood effects, raising a sense of optimism among homeowners and bolstering the value of all homes and, ultimately, the whole economy. But mortgage lenders in all their different forms lack a group strategy.
This proposal will do much to raise the hopes among loanowners looking for free money, but it will do nothing for homeowners. It probably would stimulate the economy because the first thing the loanowners and homeowners alike would do is start maxing out their HELOCs in preparation for the next crash. The smart ones would hide this money in safe-deposit boxes or overseas accounts. The dumb ones will blow it like they always do.
John Geanakoplos, a Yale economist, and Susan P. Koniak, a Boston University law professor, have proposed legislation that gives community-based, government-appointed trustees a central role. The trustees would have the authority to impose a write-down of mortgage principal that served the interests of mortgage issuers as a group, without having to prove that each and every one would be better off. But Congress has not acted on their idea. And so we are still lacking the authority to make everyone sit down.
WTF? He wants to give trustees the right to unilaterally impose mortgage write downs at their whim? Who is going to loan money to anyone in that jurisdiction? No private lender would. Perhaps we should just totally nationalize the mortgage market. That’s basically what he’s talking about.
Perhaps Mr. Shiller should contact the old Soviet Union’s central economy planners. Perhaps they could give him some useful insights on how to administer such a communist program?
ROBERT C. HOCKETT, a Cornell University law professor, has outlined another approach, which uses the principle of eminent domain, to solve this collective action problem. Eminent domain has been part of Western legal tradition for centuries. The principle allows governments to seize property, with fair compensation to owners, when a case can be made that such seizure serves the public interest.
Traditionally, we think of eminent domain law as applying to land and buildings. For example, a government can use eminent domain to seize real estate along a proposed new highway route so the highway can be built in a nice straight line. It would be absurd to expect the government to bargain with each property owner to buy a strip of land along the proposed highway route and to have to redirect the highway around a farm whose owner refused to sell. That is common sense.
But eminent domain law needn’t be restricted to real estate. It could be applied to mortgages as well.
We’re going to have government bureaucrats condemning mortgages? Who will determine which mortgages should be condemned? What happens to the mortgagee when the loan becomes condemned? Do they get a free house? Who do they pay the remainder too? What happens if they don’t pay?
Governments could seize underwater mortgages, paying investors fair market value for them. This is common sense too.
This is completely unnecessary. Simply bring back mark-to-market accounting, and the market will do this itself. Once the banks can no longer maintain the fantasy of face value on the loan, they will foreclose on the squatters and the mess will be cleaned up quickly. No eminent domain is required. Why would anyone want to empower a bureaucrat like that?
The true fair market value for these mortgages is arguably far below their face value, given the likelihood of default, with its attendant costs.
Professor Hockett argues that a government, whether federal, state or local, can start doing just this right now, using large databases of information about mortgage pools and homeowner credit scores. After a market analysis, it seizes the mortgages. Then it can pay them off at fair value, or a little over that, with money from new investors, issuing new mortgages with smaller balances to the homeowners. Taxpayers are not involved, and no government deficit is incurred. Since homeowners are no longer underwater and have good credit, they are unlikely to default, so the new investors can expect to be repaid.
Again, who absorbs the losses? If what the good professor described were feasible, banks would have done this ages ago. Unfortunately, this would expose the banks as insolvent, so mark-to-fantasy accounting has permitted them to avoid recognizing these losses for the last four years. Plus, banks don’t want to do this if it permits loan owners to stay in their properties because the attendant moral hazard.
The original mortgage holders, the investors in the new mortgages, the homeowners and the nation as a whole will generally be better off.
Bullshit. The original mortgage holders get wiped out. The bank becomes insolvent, the stockholders get wiped out, and the bondholders take a huge haircut… perhaps this idea has merit… no, not really.
There will surely be some who may not agree, like the holdout farmer opposing the highway, but eminent domain ought to be able to push ahead anyway.
You think? The guy paying the price is generally the one who will oppose the idea. If we did this to the banks, we would put them out of business — which wouldn’t be all bad — but it isn’t reasonable to make one of two parties to a private contract absorb such a one-sided change with no due process. That is communism. Remember…
San Bernardino County in California is working with a private company, Mortgage Resolution Partners, on the possibility of putting such a plan into action. We must hope this effort succeeds. If it works, it can be replicated all over the country.
But first we have to realize that much of our economic suffering takes the form of a collective action problem.
The only collective action problem here is with the banks allowing too many delinquent borrowers to stay in homes they aren’t paying for. If they collectively acted to foreclose on these people, this situation would get resolved, and we could get back to a normal real estate market.
We have to stop the wishful thinking that the problem will solve itself through a spontaneous rally in home prices.
On that we can all agree — except the banks who will cling to this fantasy until the bitter end.
We need to summon our resources to exercise the authority that allows collective action.
Professor Koniak says the solution to this problem has been so slow in coming for a simple reason: “It’s the will that’s lacking! The will!”
It’s the will, plus about three trillion dollars! Let’s get Ben to fire up the printing press, right?
Unbelievable [shakes head]. I am simply dumfounded.
They squatted for a long, long time
Today’s featured property first became distressed sometime in 2007. Now, five years later, it is finally coming to market to be sold to a stable borrower. The resolution of this bad loan has been anything but speedy.
- The property was purchased by the Ponzi family on 8/14/2003 for $396,000. The owners used a $317,000 first mortgage and a $79,000 down payment.
- On 12/11/2003 they took out a stand-alone second for $42,000.
- On 12/31/2003 they refinanced with a $333,700 first mortgage and a $94,300 HELOC.
- On 2/23/2005 they refinanced with a $500,000 first mortgage.
- On 3/5/2006 they obtained a $100,000 HELOC.
- Assuming they maxed out the HELOC, the total property debt was $600,000 and the total mortgage equity withdrawal was $205,000 in just over three years.
They defaulted sometime in 2007 and were finally served notice on 3/5/2008. They were not forced out in a foreclosure auction until 4/26/2011. They squatted for at least three full years. Then the bank sat on the property for a year while it declined in value another 10%. Real bright.
Costa Mesa Overview
Median home price is $424,000. Based on a rental parity value of $558,000, this market is under valued.
Monthly payment affordability has been improving over the last 12 month(s). Momentum suggests improving affordability.
Resale prices on a $/SF basis declined from $292/SF to $292/SF.
Resale prices have been falling for 12 month(s). Price momentum suggests falling prices over the next three months.
Median rental rates increased $25 last month from $2,291 to $2,316.
Rents have been rising for 12 month(s). Price momentum suggests rising rents over the next three months.
Market rating = 6
$400,000 …….. Asking Price
$395,000 ………. Purchase Price
8/14/2003 ………. Purchase Date
$5,000 ………. Gross Gain (Loss)
($31,600) ………… Commissions and Costs at 8%
($26,600) ………. Net Gain (Loss)
1.3% ………. Gross Percent Change
-6.7% ………. Net Percent Change
0.1% ………… Annual Appreciation
Cost of Home Ownership
$400,000 …….. Asking Price
$14,000 ………… 3.5% Down FHA Financing
3.62% …………. Mortgage Interest Rate
30 ……………… Number of Years
$386,000 …….. Mortgage
$100,956 ………. Income Requirement
$1,759 ………… Monthly Mortgage Payment
$347 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$100 ………… Homeowners Insurance at 0.3%
$402 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$2,608 ………. Monthly Cash Outlays
($264) ………. Tax Savings
($595) ………. Equity Hidden in Payment
$16 ………….. Lost Income to Down Payment
$120 ………….. Maintenance and Replacement Reserves
$1,885 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,500 ………… Furnishing and Move In at 1% + $1,500
$5,500 ………… Closing Costs at 1% + $1,500
$3,860 ………… Interest Points
$14,000 ………… Down Payment
$28,860 ………. Total Cash Costs
$28,800 ………. Emergency Cash Reserves
$57,660 ………. Total Savings Needed
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