When Loans Go Bad: Markets and Cartels

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Tuesday, 20 August 2013 20:56

Phillip Swagel used an Economix post to discuss the ramifications of debtors not paying their debts. While his basic point is valid, that reducing payments to creditors will affect their willingness to lend in the future, some of the specifics are questionable.

His first example is the case of the auto bailouts, where the terms of the bailout put some commitments to the workers (most notably retiree health care benefits) ahead of bondholders, reversing the normal ordering of creditors in a bankruptcy. While Swagel refers to research that suggests that unionized firms paid a penalty in their borrowing in the period immediately following the bailout, the logic of the situation would not support this outcome.

As a result of the government's intervention, all creditors, including bondholders, almost certainly got more money than would have been the case if the government had let GM and Chrysler go into bankruptcy without assistance. What would matter to a creditor is their expected payback in the event of a bankruptcy, not whether another creditor may be placed ahead of them in line. If the bailout allowed a higher payback for creditors than would have otherwise been the case, then it should reduce interest rates for unionized firms that might be more likely to be bailed out, not increase them. This is the outcome that Swagel indicates was supported by other research.

Swagel also looks at the case of municipal bonds in the wake of the Detroit bankruptcy. He notes that creditors will likely have to take losses on general obligation bonds which are backed by tax revenues. He mentions that this appears to be leading to higher interest rates for other municipalities in Michigan. While this may be due to the fact that Detroit bondholders will be forced to take losses, it can also be attributed to the fact that creditors had not previously assessed risks accurately.

One of the issues in the Detroit bankruptcy is the standing of pensions. While pension obligations do not hold a favored position relative to other creditors in federal bankruptcy law, Michigan's constitution prohibits pension benefits from being reduced. Since the city of Detroit is a creation of the state of Michigan, the state constitution could be seen as limiting the city's freedom of action. In this case, prohibiting it from seeking a federal bankruptcy which would not prioritize workers' pensions.

If the courts end up accepting this argument, which is the position of the state's attorney general, then the implication would be that the bondholders always stood behind pension obligations in the case of financial duress. It's possible that they failed to understand this fact, but this would not be a case of reversing the order of creditors. It would simply be a case where creditors failed to understand the actual value of the asset they owned, just as was the case with many subprime mortgage backed securities when the housing bubble collapsed.

This brings up the third case, the plan by the city of Richmond, California to use eminent domain to buy underwater mortgages out of mortgage backed securities (MBS). Swagel neglected to mention this fact in his discussion, but it is crucial to the city's argument. If the mortgage were held by a bank, then presumably a deal could be arranged between the city and the lender that would not require eminent domain. The argument of the city is that they are paying fair market value for these mortgages, this would mean that on average the lenders are not actually losing money from the transaction. (Investors can contest in court whether the compensation provided in an eminent domain seizure represents fair market value.)

However, since the mortgages in question are in MBS issued by investment banks, it is difficult for the trustees of the MBS to arrange a discounted sale that reflects the market value of an underwater mortgage. In this context, eminent domain can allow for a mutually beneficial transaction from the standpoint of the investor and the borrower that gets around the barriers created by the legal structure of the MBS. Insofar as this is the case, there is no reason at all that this should lead to higher mortgage rates in the future.

It is worth noting that the response being threatened by the Federal Housing Authority, Fannie Mae, and Freddie Mac, to boycott future mortgages from the city, is not a market response. This is the response of a cartel which collectively buys close to 90 percent of new mortgages. 

While investors will lose money from seizures compared to a situation where mortgages will be paid off in full, the vast majority of severely underwater mortgages will not be paid in full. This means that lenders already have seen a loss, even if this has not yet been recognized. The loss is not the result of the seizure.

The implication for future lending is that creditors should be wary of making loans in contexts where a rapid run-up in house prices caused them to get out of line with the fundamentals of the market. It would certainly be a change for the better if lenders became more cautious under such circumstances.