Friday, March 11, 2011

Principle Reduction in mortgages

Some of the Fed economists have interesting post about principle reduction in the mortgage modification program. The post titled The Seductive But Flawed Logic of Principal Reduction | The Big Picture is available at the big picture blog. I have a few reservations about the logic expressed by the economists.

Some reservations about the article
First and foremost, the article refers to principle reduction as mechanism to create a win-win alternative. I must disagree. Principle reduction is a mechanism for loss sharing and there is no "win" in this.

When a lender and borrower together buy a property (by its economic definition referring to any asset), they are investing in it. This is understood when lender takes to same asset as collateral in lieu of the loan extended to the borrower. The borrower, by paying the interest on the loan, gets the right of ownership of the asset. Thus ideally, the lender will have a capped upside and a capped downside while the borrower will have unlimited upside and limited downside. This is the normal situation. 

However, during the current crisis, the situation took numerous forms all radically different from the normal situation. In most of these cases borrowers or lenders or both are seen to be speculating on house prices. In such cases, the upside and downside of the speculative bet should be equally shared.

Secondly, in specific cases of lender induced speculation, downside should be specifically and singularly borne by the lender. This is particularly true of the sub-prime loan category. Here all the losses should be borne by the lender and not the borrower.

Similarly, if borrowers are alone found to be speculating then they should bear the downside of the deal. Second home purchases are indicative of speculative behavior. Thus second homes should not have principle reduction.

Consequently, a first-home buyer at the mercy of lenders should be allowed principle reduction option.

The big picture story
The main factor in the decision about principle reduction lies away from this discussion. Principle reduction may create a buffer within the household balance sheets. This buffer, it is believed, may be the solution to the current crisis. There are a lot of arguments that agree with this hypothesis.

The resolution of the mortgage side, keeping an eye on the possible macro benefits, may not be fair. But it may work to revive the economy. Keeping this in mind, the financial industry may bite its own tail to save itself and agree with the principle reduction program. In a way, this is a question of bargaining power of government with respect to banks.