Home loans gone bad? Here's a foreclosure alternative.

Home loans in distress would lead to homes with renters instead of empty foreclosed properties under this proposal. Would it really work?:

Damian Dovarganes/AP
Thousands of people line up to attend the first day of a foreclosure event organized by the Neighborhood Assistance Corporation of America Jan. 20, 2011, at the Los Angeles Memorial Sports Arena. The group is providing counseling for home owners struggling to pay their home loans and opportunities to meet with bank representatives. One proposed alternative to foreclosures would let homeowners stay in the home as renters.

David E. Papell suggests a new public policy for handling foreclosure.

"Here’s how it would work. The borrower would lose ownership of his home, but be allowed to remain as a tenant paying fair rent for a reasonable period after foreclosure, with the requirement that he cooperate in the foreclosure. He’d pay fair market rents as published by the federal government, ensuring a clear, national standard. If the borrower couldn’t afford to pay market rent, existing federal rent-subsidy programs could be extended to help tide him over.

At the same time, with borrowers now working with lenders, it would be much easier to gather all the documents necessary to process the foreclosure, unclogging the sort of paperwork roadblocks that have recently encumbered the mortgage industry. Lenders would wind up owning a portfolio of income-producing property that would be readily marketable to investors."

So, this policy proposal would give owners the option to become renters again. What are the unintended consequences of such an option?

1. Lenders will anticipate that under this policy that they are likely to be handed the keys to a large number of homes in distressed neighborhoods that they will need to hold in inventory (waiting for home prices to rise) rather than holding a more diversified market portfolio. The rational lender will charge an interest rate premium to all borrowers to cover this expected cost of default. Lenders will also have to invest in having the human capital on payroll to engage in upkeep and maintenance for the homes they would now own. If these homes are scattered across the country in weird places then there will be higher monitoring costs for doing the basics of being a landlord of a rental property (mowing lawns etc).

2. If potential home buyers know that they have an easy exit option, then more of them will try to become home owners earlier. This is a type of "adverse selection" because of the anticipation that a new exit option exists thanks to Papell's proposal.

3. His proposal is vague about what the word "reasonable" means in terms of the length of the rental contract. If the local housing market heats up again, the bank will be eager to evict the renter to sell to someone who wants to buy it. Will the renter sue in court?

4. I do like that in a static efficiency sense that his proposal lowers transaction costs and thus is "Coasian" for achieving the efficient allocation of risk at a point in time.

But, as usual with any policy proposal -- it isn't clear to me whether the dynamic effects of his proposal have been thought out. If they could be quantified, is his idea still an obvious winner?

So, dynamic economics is useful for thinking about the NY Times editorial page!


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