Interest-Only During Recessions

John Campbell et al. have posted Structuring Mortgages for Macroeconomic Stability to SSRN. They are not the first to propose a mortgage product that is designed to lessen its burden when times are hard, but that does not make their proposal any the less intriguing. The authors write,

Events in the last decade have shown that adjustable-rate mortgages (ARMs) have advantages over fixed-rate mortgages (FRMs) in stabilizing the economy, at least when the central bank has monetary independence and can lower the short-term interest rate in a recession. A lower short rate provides automatic budget relief for ARM borrowers and helps to support their spending. It can also provide some relief to FRM borrowers, but this requires both a decline in the long-term mortgage rate and refinancing, which may be constrained by declining house prices and tightening credit standards. Barriers to FRM refinancing in the aftermath of the Great Recession were an important concern of US policymakers and motivated the introduction of the Home Affordable Refinance Program. (1, citations omitted)

The authors are certainly right that mortgages were a big drag on households during the Great Recession and many of them (but not all) would have benefited from lower monthly payments. To address this, the authors

study mortgage design features aimed at stabilizing the macroeconomy. Using a calibrated life-cycle model with competitive risk-averse lenders, we consider an adjustable-rate mortgage (ARM) with an option that during recessions allows borrowers to pay only interest on their loan and extend its maturity. We find that this option has several advantages: it stabilizes consumption growth over the business cycle, shifts defaults to expansions, and lowers the equilibrium mortgage rate by stabilizing cash flows to lenders. These advantages are magnified in a low and stable real interest rate environment where the standard ARM delivers less budget relief in a recession.

While there have been some pilot programs that introduce countercyclical mortgage products, nothing has really taken off so far. Hopefully, papers like this will push lenders and regulators to keep looking for solutions to our next housing crisis, before it actually hits.

The Little-Known Escalation Clause

The Wall Street Journal quoted me in Escalation Clauses: A Little-Known Bidding-War Strategy. It opens,

For home buyers locked in a heated bidding war, there is one weapon that may help ensure victory: an escalation clause.

It’s an addendum to a real-estate contract, typically when the offer is made, in which a prospective buyer says, “I will pay X dollars for this house, but if another buyer submits a verifiable bid that’s higher, I will raise my offer in increments of Y dollars to a maximum price of Z.”

These clauses are particularly useful in a competitive real-estate market where homes typically get multiple bids. If a bidding war erupts on a home, the escalation clause will automatically raise the buyer’s offer on the house by the predetermined increment, up to the maximum amount the buyer authorizes. It eliminates the back and forth of offer and counteroffer and helps the buyer avoid paying too much for a house by getting caught up in the frenzy of a bidding war. But they can be risky for buyers who use them.

“A buyer can think of an escalation clause as a ‘have your cake and eat it, too’ clause,” says David Reiss, a Brooklyn Law School professor who specializes in real estate. “But in real estate, as with cake, it is hard to have it all.”

One concern is that the buyer is tipping his hand to the seller by using an escalation clause, Prof. Reiss says.

By indicating the maximum amount he will pay for the house, a buyer is revealing important information—that he’s willing to pay more. For example: Seller lists the house for $1 million. The buyer bids $950,000 with an escalation up to $975,000. The seller can counteroffer at $975,000, knowing that the buyer can both afford it at that price and is willing to pay it.

“Sellers get more money than they ever thought they would have,” says Carrie DeBuys, a real-estate agent with Realogics Sotheby’s Realty in Seattle. In her market, it isn’t uncommon for a seller to receive “10, 15 or 20 offers on a property.”

On the flip side, an escalation clause may not be in the seller’s best interest, explains Prof. Reiss.

Say a house is listed for $1 million, and there are three bidders. Buyer A offers $950,000. Buyer B offers $975,000 with an escalation clause that could go up to $1 million in $5,000 increments. Buyer C offers $980,000. In this scenario, the seller would get $985,000 from Buyer B after the initial offer escalates over Buyer C’s offer. But, had the seller not relied on the escalation clause and instead asked the bidders for their best and final offer, he might have sold the house for $1 million. “We know that the buyer was willing and able to go up that high,” Mr. Reiss says. “Thus, the seller is likely getting $15,000 less in the escalation-clause scenario.”