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Take the banks' umbrella away

By Gavin Putland - posted Wednesday, 9 March 2011

You know the story. A bank lends you money to buy a property in a bubble-inflated market, securing the loan with a mortgage over the property. The bubble bursts, so that the market value of the collateral is now less than the outstanding debt. For whatever reason, you stop paying the mortgage. The bank repossesses the property and sells it, receiving a price that is insufficient to cover the debt.

Now why should you be liable for the shortfall? You shouldn't. Protecting the lender against default is the purpose of the collateral. When the collateral has been seized, any further claim against the borrower is double dipping. As the lender has more power and more information than the borrower, it is the lender's responsibility to make sure the collateral will cover the debt. If the lender has failed to discern a bubble or to leave sufficient margin for the possibility of a bubble, that failure is the lender's fault and its consequences should be the lender's problem.

And why should your credit rating take a hit if you walk away? It shouldn't. The return of the collateral in undamaged condition should constitute an alternative fulfilment of the contract. Again it is up to the lender to ensure that the collateral is sufficient for the purpose.


The ability to walk away without penalty is equivalent to a put option whereby the borrower can sell the property to the lender for the amount owing. That put option will have its market price, which will be expressed in the interest rate or the set-up fee or some combination of the two. Obviously that market price will reduce the amount that the buyer can borrow to spend on the property. But, as property prices are determined by borrowing capacity, prices will adjust to compensate, and affordability will be unaffected.

Would non-recourse loans make a crash more likely, by encouraging defaults? Only if they're introduced at a time when the market is already overvalued, in which case, by forcing lenders to be more conservative, they might precipitate the crash, which in turn would encourage defaults. If they're introduced while the market is rising but not yet overvalued, that same conservatism will tend to prevent the formation of a bubble. If there's no bubble, there's no crash, hence no encouragement to default.

Yes, the great U.S. housing bubble inflated in spite of non-recourse loans in many states. But that was because the mortgages were resold, so that the original lenders didn't care if collateral values fell, whether the loans were non-recourse or full-recourse. That made the lenders reckless. The problem wasn't the non-recourse loans, but the circumvention of their essential feature: exposure of the lender to any fall in collateral values.

Even more iniquitous than full-recourse mortgages is the practice of evicting tenants when their landlords default, then selling the vacant properties -- or worse, holding them off the market in order to prop up prices and rents, and generating income as necessary by drip-feeding repossessed properties to buyers instead of letting them to tenants.

If you are a lender repossessing a rental property, you should have to honour the rental contract. If you sell the property, you should have to sell it subject to the rental contract. If that requirement makes you more cautious about lending for investment than for owner-occupation, so be it. In Australia, where negative gearing helps investors to outbid owner-occupants, that caution would tend to level the playing field.

In the mean time, if you are a tenant being evicted because your landlord has defaulted on the mortgage, you might try telling the lender that you are considering a lawsuit and/or private criminal prosecution against the lender for being an accessory to the landlord's insolvent trading. You might be able to extract a very favourable rental deal in return for dropping that threat.


If you pay off a loan early, why should the lender be allowed to charge you an exit fee? Does the fee compensate the lender for loss of interest? No, because interest is itself a compensation for alternative uses of the principal; and by returning the principal early, you allow it to be used for those alternative purposes. Does the fee compensate the lender for the cost of re-lending the principal? No, that's the purpose of set-up fees, not exit fees.

Do exit fees mean lower set-up fees? Perhaps. The ability to pay out the loan early with no penalty is equivalent to a call option whereby the borrower can buy the mortgage for the amount owing. That call option will have its market price, which can be expressed in the interest rate or the set-up fee or some combination of the two. Converting it into an exit fee makes it less visible to the borrower entering into a mortgage -- in other words, less honest. The Federal Government is therefore to be congratulated, howsoever grudgingly, for deciding to ban exit fees.

What about variable-rate mortgages, in which the stronger party to the contract can unilaterally vary the most important term in the contract after it is signed? If the "variable" interest rate were tied to some agreed measure of the lender's borrowing costs, that would at least retain an element of mutuality (not to be confused with safety). But the lender gets carte blanche. Why should the lender be allowed to vary the rate at will, or at all?

One might answer that competition between lenders protects borrowers against exploitation. That's true if exit fees are banned, so that borrowers can change lenders without incurring fees that wipe out the interest savings. But why create the problem in the first place? Why not require the interest rate to be specified up-front?

One might answer that a fixed interest rate would tend to be higher on average, because the lender would need a buffer against variations in its own borrowing costs. That's true. But property prices would fall to compensate for the fall in borrowing capacity. Hence fixed interest rates, like any other measure tending to reduce property prices, would be helpful if introduced sufficiently early in a rising market: it would lean against the formation of a bubble.

One might answer that fixed-interest-rate loans would reduce the influence of official interest rates on inflation. But there are better ways to control inflation. For example, an increase in the rate of compulsory saving would exert downward pressure on inflation without the nasty redistributive effects of a rise in interest rates.

If it's real-estate inflation that we're concerned about, we need to understand that property bubbles inflate when people pay more attention to the direction of prices ("capital gains") than to the prices themselves (and whether they are commensurate with earnings). Hence the remedy is to reduce the attractiveness of "capital gains" relative to current income -- by reducing (preferably to zero) taxes on current income, including income from assets, and increasing the public capture of land values and/or uplifts in land values.

Such reforms, which may be described as "land-value capture", make housing more affordable for both renters and buyers, because the greater need to generate income from property strengthens the bargaining position of those who can supply that income (tenants) or relieve the need for it (buyers) against those who have that need (current owners). Affordability is the balance of your amenity and your spending power against the price or rent that you have to pay. Policies that strengthen your bargaining position tip that balance in your favour.

One form of land-value capture is a holding charge proportional to the value of the land. This has the added advantage of exerting negative feedback on prices, stabilizing prices around the long-term trend: when prices rise, holding costs rise, encouraging sales and discouraging purchases, thus limiting the rise; and the opposite when prices fall.

Another form, of course, is a "capital gains" tax. This lacks the negative-feedback feature. But if it replaces an equal amount of taxation of current income or expenditure, it can arrest a price crash that is already in progress: the reduction in current taxation increases the immediate capacity of current and prospective debtors to service loans, and that immediate capacity is not diminished by the prospect of paying a higher capital gains tax at some future date.

I say this because, as is clear from recent posts at the LVRG Blog, I believe that a price crash is indeed in progress.

Why do prices peak and fall? If we make reasonable long-term assumptions concerning the interest rate, the appreciation rate, the property tax rate, and the factor by which the income tax system magnifies capital gains relative to current income, and then try to calculate the price/rent ratio that makes buying a property competitive with renting in the long term, we reach the embarrassing conclusion that prices should be infinite. So what keeps them finite? Obviously the constraints of the financial system. (Unfortunately this "obvious" conclusion and its "embarrassing" foundations are not found in my writings prior to November 2009.)

That is why, as I say above, "property prices are determined by borrowing capacity". Bubbles burst, not because prices overshoot some rational calculation of what the properties are worth, but because prices overshoot what people can reasonably afford to borrow.

But if we repeat the price/rent calculation assuming the kinds of tax reforms proposed above, we get answers that are known to be financially sustainable. Thus the ultimate significance of those tax reforms is not that they discourage the seeking of "capital gains" in excess of rational prices (although that helps), or that they apply negative feedback to stabilize prices at rational levels (although that also helps), but that they bring those "rational" prices within reach of the financial system.

Without tax reform, buying a home cannot remain affordable, because as property prices seek their "rational" level, they will rise above the saving and borrowing capacity of prospective buyers. By themselves, financial regulations that limit the borrowing opportunities of prospective buyers have little effect on affordability, because changes in borrowing power tend to be absorbed by changes in market prices.

Without tax reform, there can be no financial stability, because as property prices seek their "rational" level, they will break the financial system. By themselves, financial regulations that transfer risks from borrowers to lenders will not stabilize the financial system, but will only change the manner in which it falls over: instead of buyers losing faith in the greater fool, we'll get lenders losing faith in the greater fool.

Moreover, without tax reform, financial regulations that make lenders more cautious are not politically sustainable, because they are too easily blamed for locking prospective buyers out of the market, and because they can be repealed without any immediate fiscal impact. In contract, tax reforms by themselves can keep property prices within reach of a deregulated financial system, and cannot be undone without imposing new taxes, raising old ones, or cutting expenditure.

So, having condemned certain practices by which lenders oppress borrowers and tenants "after the fact", and having rejected the lenders' excuses, I must concede that such practices are not the cause of unaffordable housing and financial instability. The cause is a tax system that makes asset appreciation more attractive than current income.

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About the Author

Gavin R. Putland is the director of the Land Values Research Group at Prosper Australia.

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