Homeowners Alone

If you couldn’t pay your debts in the 19th century, you went to jail. Debtors’ prison seemed an appropriate punishment for what was then considered moral laxity. The problem was that when debtors were locked up, they couldn’t work off their debts or be productive citizens. That’s why bankruptcy was invented.

We seem to have forgotten this history when it comes to the biggest debt burden still hobbling most Americans—their home mortgage. Home values continue to drop. Since 2005, they’ve plummeted more than 30 percent on average and are expected to drop another 2.5 percent this year. That leaves one in five American homeowners “underwater”—owing more than their home is worth.

The result is a new form of debtors’ prison. Underwater homeowners can’t refinance at today’s rock-bottom interest rates, because they’re considered bad credit risks. They can’t move to where jobs are more plentiful or the pay is better, because if they sell their home, they end up owing the banks a bundle. But if they lose their job, their wages drop. If they have a medical emergency, they may fall behind on their mortgage payments and be foreclosed upon. If that happens, they and their family can lose both their home and their credit rating.

Although some underwater homeowners are walking away from their home and mortgage debt nonetheless, most don’t want to bear the consequences. So the new debtors’ prison is increasingly crowded. As of September, more than 4 million mortgage loans were in some stage of foreclosure or considered “seriously delinquent” by three or more payments.

Like the debtors’ prisons more than a century ago, this new debtors’ prison also hurts the economy. The rising number of vacant or foreclosed-upon homes pushes down remaining housing prices. Additional delinquencies cause banks to tighten lending standards further, making it harder for all potential buyers to purchase homes. This stymies new home construction, traditionally a major source of employment in recoveries. The Commerce Department’s latest report shows a 1.4 percent drop from July to August in single-family housing starts.

The obvious answer is to close the debtors’ prison and substitute personal bankruptcy, as we did a century ago. That way, distressed homeowners could renegotiate the terms of their mortgage while remaining in their home. This wouldn’t require thousands of bankruptcy magistrates and courts. Mere access to such a process would itself give homeowners bargaining leverage to get banks and other lenders to reorganize the loans voluntarily.

But the nation’s bankruptcy laws don’t allow primary residences to be included in personal bankruptcy, even though second homes and commercial buildings can be. This carve-out—which preceded the bursting of the housing bubble—is due to the political clout of Wall Street and the banking industry.

You might think bankers and other lenders would now be willing to renegotiate loans, at least down to the market value of the homes they finance. After all, that’s what they’d get in a foreclosure sale. But bankers fear this would force them to write down many mortgages now on their balance sheets at the older, higher nominal values. When these mortgages go into default, it’s more expedient for them to foreclose and resell the properties one by one and to take the losses against their taxable earnings.

This is why Treasury Department initiatives designed to encourage banks to voluntarily modify mortgages haven’t had much success. Even though this new debtors’ prison is a major impediment to economic recovery, the White House efforts to confront this problem have been half-hearted.

Tellingly, the White House has never confronted the bankers directly on amending the laws to allow homeowners to declare bankruptcy on their primary residences. It didn’t even make this a precondition for giving Wall Street the giant bailout of 2008.

The reason goes beyond the bankers’ political clout. White House political operatives know that a significant number of Americans don’t like the idea of relieving distressed homeowners. It’s a moral issue with them. Mortgages are the single-largest financial obligation most middle-class Americans have, and they don’t see why those who took on too much mortgage debt should get a break. As CNBC’s Rick Santelli famously ranted in 2009, responsible Americans shouldn’t have to “subsidize the losers’ mortgages.”

So we’re back to 19th-century morality. Even though today’s debtors’ prison doesn’t literally lock people up, it locks them into neighborhoods and regions without jobs and into payments they can barely afford. As a result, it’s locking the rest of us into a seemingly endless recession.

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