Riding the downward spiral
Assembly Speaker Barbara Buckley has introduced a bill that would supposedly stabilize Nevada's housing market and assist homeowners who are in danger of foreclosure.
Speaking in support of the bill, Buckley expressed concern over the "free fall" of home values in Nevada. Unfortunately, the legislation would actually result in even greater turmoil in the housing market.
The plan would require mortgage lenders to first offer "mediation" to defaulting homeowners before selling the non-performing loans to other companies or reclaiming the property through foreclosure. During the mediations, defaulting homeowners would be able to ask mediators appointed by the Nevada Supreme Court to restructure and reduce the value of the loans and the level of the defaulting homeowners' indebtedness.
In effect, Buckley's plan would force mortgage companies across the state to undertake a massive write-down on the value of their assets. Mortgage companies would be prevented from selling their assets at the current value and, hence, the market value of those assets would be diminished even if a firm does not consider their sale. In a financial market that is already hemorrhaging, this forced write-down could endanger the solvency of mortgage companies in Nevada.
The financing of a home generally involves a shared risk between the homeowner and the lender. The homeowner takes the risk that the value of the home will change in one direction or the other and the lender assumes the risk of default if the homeowner does not keep up with the payments. Buckley's plan would shift all of the risk onto the lender.
This shift would drastically distort the incentive structure for both homeowners and mortgage companies. It would send a signal to homeowners that they can lower their amount of outstanding debt simply by stopping payment on their home loans and forcing the mortgage company to go to mediation. Then, the value of the loan could be reduced to current market value of the home and the lender, not the homeowner, would be forced to take the hit. Indeed, the plan would likely induce homeowners who are not in danger of foreclosure to consider this approach.
Mortgage companies, who would be forced to assume all of the home buyer's risk under the Buckley plan, would likely respond to this change in the incentive structure by refusing to make new loans. In order for a mortgage company to remain profitable under such an incentive structure, the company would need to receive a return on investment that is large enough to compensate the company for the additional risk Buckley would force it to assume. This means that the Buckley plan would push interest rates on home loans up to unprecedented levels.
Rather than stabilize the housing market, Buckley's scheme would have the exact opposite effect. In markets for durable goods, such as housing, there is generally a trade-off between prices and financing costs. For instance, the artificially cheap credit created by the Federal Reserve's aggressive monetary expansion over the past decade fueled a corresponding artificial spike in housing prices. The lure of lower financing costs drew more consumers to the market—elevating the demand—which drove up prices.
The fact that Buckley's plan would force mortgage lenders in Nevada to charge extremely high interest rates means that it would have the opposite effect on housing prices. The higher financing costs would drive consumers out of the housing market and this drop in demand would further hasten the decline in home values.
Buckley has estimated that "48 percent of homes in Las Vegas are valued at less than what their buyers owe on their mortgage." Yet, her plan would cause this number to rise by accelerating the decline in home values.
The predictable outcome of this result would be that the number of home loans being called into mediation would steadily increase over time—exposing mortgage companies to ever greater write-downs on the value of their assets. They would then seek even higher return rates on their investments. Demand for housing would decline. Housing values would fall further. New mediation cases would result.
Repeat ad nauseum.
Speaker Buckley and her colleagues in the legislature should seriously consider the unintended consequences that invariably result from government intervention into the marketplace. Speaker Buckley's homeowner bailout plan, while well-intentioned, would send the housing market in Nevada into a downward spiral from which recovery would be nigh impossible.
Geoffrey Lawrence is a fiscal policy analyst at the Nevada Policy Research Institute.