Post by Bob Hockett: 'Lease Swaps' as Mortgage Market Cure
By Bob Hockett (NB from Mike: Bob asked me to note that Lynn LoPucki and another who wishes to remain anonymous were very helpful in his development of the proposal described here.)
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One general prospect that I think deserves more attention than it seems generally to attract is that of financial innovation on behalf more directly of proverbial 'Main Street,' to supplement those many very clever innovations, some admittedly perhaps 'too clever by half,' that regularly come down the pike to the benefit of proverbial 'Wall Street. Indeed, it seems to me that many potential innovations that might directly benefit the former would ultimately redound indirectly to the benefit of the latter as well. The following idea is offered in that spirit.
First a brief bit of contextualization. So, as many of our readers are doubtless aware, the chief drag upon consumer demand, hence employment, in the U.S. economy right now is ongoing post-bubble delevering on the part of American households. This is a process that, if the example of Japan since the early 1990s serves as any indication, could take many more years to complete. Indeed, in our case, the debt overhang per capita is more formidable even than that of Japan – an ominous consideration, to say the least.
Next, as many of our readers also know, a significant component - if not indeed the principal component - of the mentioned overhang shows up in the form of mortgage debt. So significant is this component that millions of American home mortgages are in fact 'under water.' That is, the market values of the underlying homes are significantly less than the nominal debts still owed on the mortgages. It is not difficult to appreciate how owing more on one's home than that home is now worth might dampen one's propensity to spend on consumption. Indeed, it is not even difficult to appreciate why many mortgagors might even find it financially rational, if nevertheless morally discomfiting in some cases, to 'walk away' from their homes and their mortgage debts under such circumstances.
For these reasons, not a few observers of the underlying causes of our ongoing debt deflation now argue that many mortgage debts simply will have to be significantly restructured - even to the point of reducing principal. For one thing, principal reduction might well be fundamentally fair in many cases - at least in such cases, which surely are many, as those in which neither borrower nor lender was better situated to appreciate that an ultimately unsustainable housing bubble was underway at the time that the debt was incurred. Think in terms of comparative fault in the law of tort here. But don't rest on this consideration alone, for ...
Even apart from considerations of fundamental fairness, principal reduction is apt to prove necessary in many cases simply in order to avoid yet greater loss – loss not only to debtor, but also to creditor, and indeed also to all participants in the macroeconomy, inasmuch as our ongoing debt deflation stands to deprive all of us of many years' worth of economic growth looking forward. It is for this reason, of course, that even many economists who often are labeled 'conservative' favor principal reductions in the cases of many now underwater home mortgages.
Where the only apparent alternative to principal reduction is mortgagor 'walkaway' or lengthy and costly foreclosure proceedings, principal writedowns are value-maximizing. The net present values (NPVs) of the asset sides of financial institutions' balance sheets, too, are accordingly apt to look better, in the long run, and the financial system itself accordingly healthier, where mortgage loans can be restructured in manners that include partial writedowns. And lien-holders know this.
What, then, stands in the way? There are a number of factors, as I and many others catalogue elsewhere. But certainly one very formidable obstacle is the notorious 'creditor collective action problem' that afflicts most troubled loan workouts. The problem, in other words, is the 'holdup' power wielded by some lienholders who wish to take larger 'slices of the pie' than they ought to have in comparison to other, prior lienholders. A particularly salient instance at present is that of those who hold secondary liens on mortgaged homes pursuant to home equity lines of credit (HELOCs) extended to homeowners during the bubble years.
Now, our legal tradition, particularly thanks to the old courts of equity, registers strong appreciation of the creditor collective action problem, as well as the need to be able to break through it sometimes. It does so, of course, through the institution of bankruptcy. Bankruptcy is expressly designed to solve creditor collective action problems, by enabling bankruptcy judges, sitting in equity, to act on behalf of the full collectivity of creditors with a view to maximizing the NPVs of troubled loans.
But alas, bankruptcy is not generally available right now where it is needed most by debtors, creditors in aggregate, and all of us who would like to avoid years and years of macroeconomic stagnation ahead. For 'primary residences' are excluded from the U.S. Bankruptcy Code's protections, by Section 1322(b)(2). Members of Congress have of course noticed the problem, and have accordingly proposed legislation to remedy it repeatedly over the past several years. But in the current political climate, of course, these initiatives - like just about all initiatives that might plausibly aid in ending our present economic ills -- have unsurprisingly gone nowhere.
But now go back in memory to your law school years and consider this: Surely one's 'primary residence' for Bankruptcy Code purposes need not be held in what property lawyers call 'fee simple,' right? Surely instead it can be held in the form of a 'leasehold' Well, then, what if troubled mortgagors were to make use of the now well developed infrastructure of web-based 'house swapping' that has developed in recent years - essentially, as a means of house barter where tight credit conditions have shrunken the money supply in the housing market to near zero - as a means of 'lease swapping' rather than 'fee simple swapping'?
Here's how it would work: A moves out of the house that he owns in fee simple, and leases B's house. B moves out of the house that she owns in fee simple, and leases A's house. A and B both file for bankruptcy. Each is now able to modify his or her own mortgage because the mortgage is on a house that is not the debtor's 'principal residence.' (To preempt arguments that some dissenting creditors might make, to the effect that A and B intend all along to move back into their original homes later, which would render these still their principal residences, let A and B contractually commit not to swap back.)
Beautiful, no? And what judge or lawyer could object? Those who are concerned with fundamental fairness, efficiency, or both will surely approve, just like the debtors and primary creditors themselves. Those who don’t care about fairness or efficiency, most of whom seem to be ‘textualists,’ cannot balk either, can they? ‘Primary residence’ means primary residence.
Now, were many people to avail themselves of the prospect we’re floating here, it seems to me it would offer at least three welcome benefits. First, it would enable home owners with troubled mortgages - as well as their creditors in aggregate - to enjoy the benefit of value-maximizing bankruptcy protection - which, again, is precisely what bankruptcy is for. Second, this very prospect, simply by dint of its status as an option available in the marketplace, might serve at long last to break through the logjam of creditor collective action challenges to sensible principal-reductions for troubled mortgages economy-wide. And finally third, the latter development itself would then eliminate the principal source of debt overhang now underwriting our ongoing demand- and employment-dampening debt deflation. We would avoid becoming Japan.
Now of course, this will work only, if at all, for lease swaps, not ownership swaps. For the latter would surely be viewed by the courts as 'fraudulent conveyances' - actual transfers of title intended to defraud creditors – ineligible for bankruptcy protection. But limiting the method to leases is of course fine, for lease swapping is all that we need here to qualify for the NPV-maximizing bankruptcy solution to the creditor collective action problem. And simply moving, as lease swapping entails, is rather less readily characterized as a transfer, hence as a fraudulent transfer, than would be ownership-conveyance. Certainly it's not a transfer of title, as distinguished from a transfer of resident, and it's the former to which fraudulent conveyance appertains.
It's also the case that this solution is helpful only for 'underwater' mortgages, since debtors with equity lose the Bankruptcy Code's equity exemption not only by transferring title, but also by moving out. But this is fine too, for two reasons. First is that underwater mortgages constitute by far the most vexing component of that post-bubble debt overhang that is at work in our debt deflation. And second is that underwater homes are those from which debtors are most tempted to 'walk away,' meaning that creditors themselves have yet another reason to favor the bankruptcy availability that lease swapping could bring in these cases.
The more you think about it, then, the more workable it looks. And it even ought to look more familiar than I suspect that it does. Why? Because thousands of lawyers out there learned bankruptcy and related law from LoPucki & Warren's classic Secured Credit casebook, and Problem 14.3.d in that casebook, now in its 6th edition, countenances a possibility much like that we're imagining here. So ... creditors, debtors, lawyers and other advocates looking for NPV-maximizing solutions to our continuing mortgage troubles, what say you?