Eliminating Most Foreclosures: An Innovative and Just Approach to Mortgage Delinquencies
The economic and personal consequences of foreclosure are devastating. Foreclosures leave behind not only blighted neighborhoods, but ruined lives. Furthermore, during the past three years, immense abuses of the foreclosure process have come to light – with numerous banks being found to have improperly foreclosed on thousands of homeowners. The banks have either been unable to produce documentation that demonstrated their right to foreclose – or, worse, have foreclosed on individuals who were never even delinquent or did not have mortgages in the first place (see, for instance, here, here, and here). The violations of due process, private-property rights, and the rule of law have been astounding.
At this point, any solution that can reduce the number of foreclosures will be a welcome benefit to individual liberty, the US economy, and millions of Americans. Indeed, the concept of foreclosure – the expropriation of one’s home – resulting from a few late payments has always struck me as draconian. It disregards one fundamental fact: the homeowner has equity in his or home, even if he or she fails to make a few scheduled payments. So, suppose that a homeowner has a $150,000 outstanding mortgage loan on a home whose market value is $200,000. This means that the homeowner’s equity in the home is $50,000 – or one quarter of the home’s value. If the homeowner fails to make a $1000 hypothetical monthly payment on time, why is the bank entitled to appropriate the entire home and thereby deprive the homeowner of the entire $50,000 in equity? Suppose, as is often the case these days, that the foreclosure proceedings drag on for a year. A 5000% annual rate of interest for that one delinquent payment is quite steep indeed!
While delinquencies ought to be penalized, wholesale expropriation of a home is an unnecessary and disproportionate response in most cases. It would not have been possible on a truly free market, where roughly equal negotiating power would exist between lenders and borrowers. In today’s politicized financial environment, however, the large banks receive all of the privileges: bailouts, loan guarantees, access to “free money” from the Federal Reserve, barriers to entry for smaller competitors, the ability to “securitize” personal loans through means of dubious accountability, the ability to flout laws such as those pertaining to mortgage modifications, and a swiftly operating “revolving door” between bankers and politicians. Thus, homeowners are often left to acquiesce to terms that are far harsher than what they could have gotten for themselves in a truly free market.
A more equitable solution, that recognizes that the real value of the homeowner’s equity, is not to foreclose, but rather to reduce the homeowner’s equity for each delinquent payment. If the homeowner fails to make a scheduled payment, then the bank should be able to recoup its resulting losses – by seizing the portion of the homeowner’s equity corresponding to the amount of the delinquency, perhaps also incorporating an interest charge at the prevailing market rate. Only when all of the homeowner’s equity has been exhausted in this way should the bank have the right to foreclose. In today’s housing market, where many homes are “underwater” (i.e., the mortgage balance exceeds the market price, which has declined precipitously since the days of the housing bubble), this solution would still mean that some foreclosures would occur. But the number of foreclosures would be greatly reduced, and the majority of currently planned foreclosures would never occur. Furthermore, the “underwater” homeowners could still be helped by downward principal modifications that recognize the illusory and unsustainable nature of the inflated market prices that existed during the housing bubble and that were fueled by the expansionary monetary policy of the Federal Reserve. Homeowners should not be made to suffer for the Federal Reserve’s blunders.
Under my proposed approach, the mere involuntary loss of one’s job, or a catastrophic illness, would not put one’s place of shelter in immediate jeopardy. Rather, in the time that it takes for the homeowner’s equity to be exhausted, the homeowner would have the opportunity to attempt to regain his or her employment or health. Furthermore, with fewer foreclosures, the unsightly, wasteful, and dangerous effects of neighborhood blight would be greatly scaled back. A homeowner will still largely maintain his or her residence, even if he or she cannot make a regular mortgage payment. But once a home enters foreclosure, it suffers from deterioration and decrepitude at best – and outright vandalism and destruction at worst.
In rolling back the political privileges of the large banks, it is essential to compensate ordinary, law-abiding, innocent homeowners for the damage that these special privileges have wrought. The benefits of years of hard work and consistent mortgage payments should not be nullified overnight by a single delinquency. Over a year ago, in “Wrongful Foreclosures and the Free Market”, I advocated breaking up the bailed-out banks and declaring a temporary moratorium on foreclosures. Rewriting foreclosure law to require the exhaustion of the homeowner’s equity before a foreclosure can be initiated can be another step to wipe out most foreclosures at the stroke of a pen – while restoring an outcome more compatible with individual liberty, true market freedom, and natural justice.