The Volokh Conspiracy - Chapter 13 reform: the Zingales plan

In my last post, I described Durbin's bill for reforming Chapter 13. Luigi Zingales, a professor at the business school of the University of Chicago, has made the following proposal, which can be treated as an alternative to Durbin's approach.

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4% in the last two years.

How do we implement this? Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level. Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property….

In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.

Zingales's plan would help mitigate the three difficulties I identified before.

First, the entire Chapter 13 bankruptcy process, with its costs and delays, would be avoided. Rather than renegotiating the mortgage, in a process that involves the debtor, the judge, the loan servicer, and perhaps others, the mortgage is simply revised "automatically"—though presumably some public official would need to be involved.

Second, the use of housing prices by zip code as a proxy for distress reduces the risk of opportunism by debtors, although it does not eliminate it completely. It nicely captures the problem, which is one of contagion. The implicit assumption is that loss of value of a house as a result of foreclosure is likely to be greater if neighboring houses are also being foreclosed than if the neighborhood is stable.

Third, giving the mortgage holder(s) equity in the house should reduce the incentive of debtors to use the plan opportunistically, since they will only enjoy part of the upside if housing prices recover; therefore, the plan should have less of a detrimental effect on the cost of credit going forward.

This debt-for-equity swap is the most interesting element of Zingales's plan. In Chapter 11 reorganizations, debt-for-equity is standard operating procedure: equity is wiped out and debtors' claims are converted into equity interests. Zingales implicitly proposes to transfer this approach to Chapter 13.

Unfortunately, there are some serious grounds for skepticism. Zingales points out that it is not unknown for third parties to have equity interests in houses—universities sometimes provide housing support to faculty in this way (I suspect, however, for tax reasons). But if it were such a great idea, it would be a lot more common.

Consider how this might work. Suppose you are a first-time home buyer, and you would like to buy a $200,000 house. Your bank offers you a $160,000 mortgage, so you must come up with $40,000 as your down payment, which will be your equity. Suppose you say to your neighbor, or some other financial institution, "if you give me $20,000, I will give you a 50% equity stake in my house." Any takers? An equity interest in someone else's house is surely a bad investment. You have no idea what that person is doing with his house and you have no control over it even if you do (unless you demand voting rights …). Meanwhile, the other person has distorted incentives: at the margin, he'll put money in the house that improves its idiosyncratic value for him rather than money that improves its resale value. These equity interests would not be very liquid, either.

So I can imagine very easily mortgage holders saying "no thanks" to the equity interest (indeed, the law would need to be changed to allow banks to accept an equity interest, and think what those interests would do to their balance sheets!). And if you think it is hard to value a MBS now, imagine what it would be like if each security gives you a right not only to a slice of principal and interest but also to some impossible-to-determine upside. (They will be worth more, however, under Zingales' plan.) I suspect that government-supplied mortgage assistance would be more straightforward and efficient. The Chapter 11 setting is different; there, trade creditors who unhappily end up with some equity shares can sell them immediately to people who are in a position to monitor the firm.

The plan would also probably be hard to swallow, politically. Suppose I have a mortgage of $380,000 and a house worth $280,000 and that houses in my zip code declined by 50 percent. Hence, my new mortgage would be $190,000. If I immediately sold my house, I would get to keep half of the equity, that is, one half of $90,000 or $45,000. The mortgage holder would receive $190,000+$45,000 = $235,000, which is $145,000 less than the original mortgage. To be sure, that is more than the post-foreclosure value of the house ($140,000). The whole idea is to avoid foreclosure with the result that a surplus is created, which is divided between the debtor and creditor—the essence of renegotiation. But I think it would be hard for people to stomach homeowners, especially "flippers," walking away with a big profit.

Still, the idea is clever, and perhaps some variant would be more plausible. What do readers think? Can it be improved?

	[Eric Posner, January 22, 2009 at 10:33am] Trackbacks Chapter 13 reform: the Zingales plan In my last post, I described Durbin's bill for reforming Chapter 13. Luigi Zingales, a professor at the business school of the University of Chicago, has made the following proposal, which can be treated as an alternative to Durbin's approach. Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4% in the last two years. How do we implement this? Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level. Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property…. In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder. Zingales's plan would help mitigate the three difficulties I identified before. First, the entire Chapter 13 bankruptcy process, with its costs and delays, would be avoided. Rather than renegotiating the mortgage, in a process that involves the debtor, the judge, the loan servicer, and perhaps others, the mortgage is simply revised "automatically"—though presumably some public official would need to be involved. Second, the use of housing prices by zip code as a proxy for distress reduces the risk of opportunism by debtors, although it does not eliminate it completely. It nicely captures the problem, which is one of contagion. The implicit assumption is that loss of value of a house as a result of foreclosure is likely to be greater if neighboring houses are also being foreclosed than if the neighborhood is stable. Third, giving the mortgage holder(s) equity in the house should reduce the incentive of debtors to use the plan opportunistically, since they will only enjoy part of the upside if housing prices recover; therefore, the plan should have less of a detrimental effect on the cost of credit going forward. This debt-for-equity swap is the most interesting element of Zingales's plan. In Chapter 11 reorganizations, debt-for-equity is standard operating procedure: equity is wiped out and debtors' claims are converted into equity interests. Zingales implicitly proposes to transfer this approach to Chapter 13. Unfortunately, there are some serious grounds for skepticism. Zingales points out that it is not unknown for third parties to have equity interests in houses—universities sometimes provide housing support to faculty in this way (I suspect, however, for tax reasons). But if it were such a great idea, it would be a lot more common. Consider how this might work. Suppose you are a first-time home buyer, and you would like to buy a $200,000 house. Your bank offers you a $160,000 mortgage, so you must come up with $40,000 as your down payment, which will be your equity. Suppose you say to your neighbor, or some other financial institution, "if you give me $20,000, I will give you a 50% equity stake in my house." Any takers? An equity interest in someone else's house is surely a bad investment. You have no idea what that person is doing with his house and you have no control over it even if you do (unless you demand voting rights …). Meanwhile, the other person has distorted incentives: at the margin, he'll put money in the house that improves its idiosyncratic value for him rather than money that improves its resale value. These equity interests would not be very liquid, either. So I can imagine very easily mortgage holders saying "no thanks" to the equity interest (indeed, the law would need to be changed to allow banks to accept an equity interest, and think what those interests would do to their balance sheets!). And if you think it is hard to value a MBS now, imagine what it would be like if each security gives you a right not only to a slice of principal and interest but also to some impossible-to-determine upside. (They will be worth more, however, under Zingales' plan.) I suspect that government-supplied mortgage assistance would be more straightforward and efficient. The Chapter 11 setting is different; there, trade creditors who unhappily end up with some equity shares can sell them immediately to people who are in a position to monitor the firm. The plan would also probably be hard to swallow, politically. Suppose I have a mortgage of $380,000 and a house worth $280,000 and that houses in my zip code declined by 50 percent. Hence, my new mortgage would be $190,000. If I immediately sold my house, I would get to keep half of the equity, that is, one half of $90,000 or $45,000. The mortgage holder would receive $190,000+$45,000 = $235,000, which is $145,000 less than the original mortgage. To be sure, that is more than the post-foreclosure value of the house ($140,000). The whole idea is to avoid foreclosure with the result that a surplus is created, which is divided between the debtor and creditor—the essence of renegotiation. But I think it would be hard for people to stomach homeowners, especially "flippers," walking away with a big profit. Still, the idea is clever, and perhaps some variant would be more plausible. What do readers think? Can it be improved?