[Volokh] Eric Posner: Chapter 13 reform: the Zingales plan

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Posted by Eric Posner:
Chapter 13 reform: the Zingales plan
http://volokh.com/archives/archive_2009_01_18-2009_01_24.shtml#1232638414


   In my last [1]post, I described Durbinâs bill for reforming Chapter
   13. Luis Zingales, a professor at the business school of the
   University of Chicago, has made the following [2]proposal, which can
   be treated as an alternative to Durbinâs 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 propertyâ¦.

     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.

   Zingalesâs 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 âautomaticallyââthough
   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
   Zingalesâs plan. In Chapter 11 reorganizations, debt-for-equity is
   standard operating procedure: equity is wiped out and debtorsâ 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 housesâuniversities 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, âif you give me $20,000, I will
   give you a 50% equity stake in my house.â Any takers? An equity
   interest in someone elseâs 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 â¦).
   Meanwhile, the other person has distorted incentives: at the margin,
   heâll 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 âno thanksâ 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 Zingalesâ 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 creditorâthe essence
   of renegotiation. But I think it would be hard for people to stomach
   homeowners, especially âflippers,â 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?

References

   1. http://volokh.com/posts/1232596135.shtml
   2. http://faculty.chicagogsb.edu/luigi.zingales/research/PSpapers/plan_b.pdf