Foreclosures are the Solution, Not the Problem

In the WSJ, there is a well reasoned argument by Ramsey Su of why government attempts to prevent the current surge of foreclosures from occurring is actually harmful. A house is foreclosed on when either the homeowner is unable to make his mortgage payment or when he refuses to pay even if he has the capacity to make the payment because he has negative equity in his house. In the first case, a foreclosure relieves the homeowner of an expense that is too burdensome. In the second case, a foreclosure immediately improves his balance sheet because his mortgage debt is wiped out.

Some of the measures being proposed to stem the tide of foreclosures are intended to lessen the mortgage payments and/or balance as to improve the financial obligations of the homeowner. But this would be difficult to achieve under current laws since many mortgages were securitized where there are junior lien holders who would need to agree to such a modification. The problem is that such a modification would immediately wipe these investors out. They would be better off foreclosing and hoping to salvage some value later on.

Then there is the prospect of Congress passing mortgage cram-down legislation which will allow bankruptcy judges to force creditors to accept a reduction in mortgage principal and interest. This sort of government intervention only further adds uncertainty to the MBS and CDO markets and scares off prospective investors.

One of the main concerns with foreclosures is that they can cause a flood of homes to come on the market pressuring prices and worsening the current real estate downturn. But the current real estate downturn stems from the fact that the supply of homes greatly exceeds the demand. Therefore, a sharp decline in prices is needed to restore equilibrium. Foreclosures help to speed up this process and the time needed for the market to recover.

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