Schafer: Here's an idea to keep homeowners above water

What if all we know about the cause of the Great Recession is plain wrong?

What if it wasn't the financial crisis that followed the September 2008 collapse of the investment bank Lehman Brothers, as the bubble burst in housing and mortgage backed securities?

It's a question that really matters if we want to avoid another Great Recession.

And as two professors argue in a convincing new book called "House of Debt," we really don't get what caused the severe downturn. Of course that also means that thousands of pages of new financial regulations may not have done much to fix what's broken.

For the authors, Atif Mian of Princeton and Amir Sufi of the University of Chicago, the main problem is the structure of the mortgage market and how it causes housing price declines to crush consumer spending.

By the late summer of 2008, the family balance sheets of many lower middle-class homeowners had already badly deteriorated, and consumption spending had slid. Automobile sales for the first eight months of 2008 were off about 10 percent from the year before.

Things certainly got a lot worse after Lehman Brothers tipped over and the financial markets seized up, but by then the Great Recession was already well underway.

Mian and Sufi explain that the poorest one-fifth of U.S. homeowners, folks who in 2007 had total debt as a percentage of total assets of about 80 percent, were already deep in recession. In 2007 their net worth was almost exclusively the equity they had in their houses. They were vulnerable to falling prices, and prices had started to fall.

If the $200,000 house with a $160,000 mortgage declined in value 10 percent, the homeowner's net worth got cut in half.

That may not seem like a big deal, if you assume housing prices will come back. But what if prices drop 20 percent? Now the homeowner just saw net worth go to zero.

So the homeowner cut back restaurant outings, clothing, cable TV, whatever could be cut.

But while the net worth was collapsing for lower middle-class homeowners, the mortgage holder could have been just fine. The $200,000 house had declined in value to $160,000, the amount of the mortgage. The homeowner is wiped out, but the mortgage holder had yet to take a nickel in losses.

This kind of financial pain for homeowners wasn't uniformly spread throughout the country. But the authors found that from 2006 to 2009 in the counties with the largest decline in homeowner net worth, consumer spending fell by almost 20 percent.

This was so massive that it wasn't just the nearby shops and hair salons that felt the pain.

So if the American homeowner was under that much pressure, and if that led directly to a national economic slowdown, then doesn't it make sense that the homeowner should have gotten some assistance?

Yes, they wrote, but it didn't really work out that way.

One of the problems was that the bankruptcy laws prevent judges from writing down mortgage debt on a primary residence, known as a cram down.

The idea behind this was that preventing a cram down gave lenders more confidence to loan money.

A bill to ease the cram down rules died on its way through Congress, and other programs to give homeowners help on mortgage principal did not accomplish much. It didn't help that the mood in much of the country swung against the overleveraged homeowner.

If you didn't see CNBC reporter Rick Santelli deliver his famous rant from a Chicago trading floor in early 2009, it's still on YouTube. You see Santelli turning to shout at the traders, "How many of you people want to pay for your neighbor's mortgage that has an extra bathroom and can't pay their bills?"

More recently a senator from Tennessee tossed rocks at the Obama administration for a proposal to write down principal on underwater home mortgages at the taxpayers' expense, insisting that Tennesseans had acted responsibly in paying for their houses and shouldn't pay for those who hadn't.

But it turns out jobs in Tennessee are as dependent on the performance of the rest of the economy as they are anywhere else. A lot of cars get assembled there, and during the Great Recession, one out of every four Tennesseans working in an auto plant lost their job.

So if anybody thinks principal reductions are only about helping unlucky or unwise consumers with their mortgages, the authors suggested, they are not thinking clearly.

The good news is that they think they have a relatively simple fix that won't require any Chicago traders to subsidize the neighbors.

One purpose of the financial system is to spread risk, they wrote. The current mortgage market concentrates all the risk on the homeowner.

Mian and Sufi called their idea the shared-responsibility mortgage. In effect, it makes the lender and homeowner partners.

If housing values decline 10 percent, the mortgage payment declines by a like amount, and in effect the mortgage principal balance declines. Why would a lender sign up for this risk? They would do it for a higher interest rate and 5 percent of the capital gain when prices increase and the house is sold.

This structure makes the lender a more careful underwriter. But the best feature is that the net worth of the homeowner won't go to zero, and the spending that drives so much of the economy won't roll off the table.

Even though the authors aren't exactly advocates of bailouts, they can't help but point out that it was the shareholders and creditors of the big banks that got bailed out the last time.

Given that the economic crisis began with middle-class families with a mortgage problem, if anyone got a break it should have been them.

lee.schafer@startribune.com • 612-673-4302