Can Treasury Nudge Lenders Into More Short Sales? Don't Bank On It
The U.S. Treasury is trying to break up the logjam that's holding back the housing market. The problem is that many homes are worth less than the principal balance on their mortgages. The government hopes to encourage all parties involved to accept short sales in some of these cases, allowing homeowners to get out from under the debt without declaring bankruptcy, and banks to get some percentage of their investments back without going through costly and cumbersome foreclosures.
But lenders don't favor short sales because accepting them means writing off the portion of the mortgage that won't get repaid. Homeowners, meanwhile, don't want their credit ratings besmirched. So the Treasury Department is proposing to spread a little money around to the participants in the mortgage market to give all parties a little more incentive to consider the option. Will this plan work? Unfortunately, no.
Let's look at the details of the government's proposal: The New York Times reports that, starting April 5, if a bank that's collecting payments on a mortgage allows the homeowner to sell the home in a short sale, the bank will get $1,000. If there's a second mortgage on the property, the bank can get another $1,000. And the government will give $1,500 in "relocation assistance" to the homeowners doing the short sale.
In theory, this program sounds great. If the incentives worked, the investment pools that own many home loans would get more cash than they would if the house went into foreclosure. Borrowers might suffer less damage to their credit ratings and they would not be sued for unpaid balances. Communities would suffer fewer vandalized houses -- about half of all foreclosed properties are ransacked by either the former owners or vandals.
This program is a classic example of "nudgenomics." What's that? A theory propounded by Nudge co-author Cass Sunstein, now director of the White House Office of Information and Regulatory Affairs, and a former University of Chicago Law School colleague of President Barack Obama. As I wrote in an article last year, the basic notion he propounds in Nudge is simple: Give people the right incentives -- through choice architecture -- and they will choose the "right" course of action.
How Big a Nudge is Enough?
There are three tests of such a program:
Is the incentive big enough to change the decision-makers' behavior?
Will all the system participants benefit?
Will it achieve a government goal as a side-effect?
If we apply these three tests to the short-sale program, we get an unsatisfactory result. Here's why:
The incentives aren't big enough to change the decision-makers' behavior. In the case of a short sale, there are many key players, each with different incentives. The homeowner wants to sell his house, but does not want a blemish on his credit record. The servicing bank wants to get back the principal on the loan; it hopes that the cost of carrying that mortgage on its books will pay off when the housing market recovers. And the mortgage investor wants to avoid taking a write-down. If the bank has a $300,000 mortgage on a house that gets sold for $200,000 in a short sale, the government's $1,000 nudge is unlikely to change the bank's behavior unless the bank is convinced that the $200,000 deal is the best that it will ever be able to get for the property.
All the system participants will benefit -- but not enough to make the program work. The entire program hinges on what a real estate agent decides the property's market value really is. And that figure is subject to fraud. Thomas Lawler, a former executive at the Fannie Mae, told The New York Times that short sales are "tailor-made for fraud." And that could make banks very reluctant to go along with these deals. Moreover, banks that accept short sales will need to raise capital to offset their losses.
It could achieve a government goal as a side-effect. If the plan actually encouraged people to buy real estate at depressed prices, it would achieve the government aim of unfreezing the housing market. Unfortunately, the banks would need to raise capital to take the hits to their balance sheets associated with realizing the losses. And if the government ends up supplying that capital, the costs of the program could outweigh its benefits.
Back to the drawing board, Professor Sunstein.
