Thursday, November 15, 2012
Ian Ayres (Yale) & Joshua Mitts (J.D. 2013, Yale), Three Proposals for Regulating the Distribution of Home Equity:
Micro-lending decisions about four specific kinds of mortgage terms when present in a substantial cluster of mortgage contracts can exacerbate macroeconomic risk by increasing the chance that the housing and lending markets will have to absorb a wave of simultaneous defaults after a downturn in housing prices. These four volatility-inducing terms – low down payments, deferred or non-amortizing principals, balloon payments, and interest rate resets – increase the risk of lender default by increasing the chance that either the borrower will stop making payments on a mortgage with negative equity or that lenders will refuse to refinance loan principles with negative equity. In contrast, during the 'amortization era' (when mortgagors were more likely to borrow at different times, with more substantial down payments, and more continual rates of amortization, without a need to refinance), an equally sized negative shock to housing prices would likely produce less negative equity, to a smaller set of borrowers. Instead of prohibiting the volatility-inducing terms, we propose three policies to better assure a greater diversification in the distribution of equity: a modified home-mortgage interest deduction; a modified risk-retention requirement under Dodd-Frank; and most importantly, a system of leverage licenses. Limiting the simultaneous clustering of negative equity mortgages can reproduce the structural advantages that were a natural byproduct of the amortization era where inevitable downturns would disparately affect homeowners with different levels of equity.