Wednesday, January 26, 2011

The Exemptions Howler Again (With Walkback)

[Caution, walkback:  on sober reconsideration, I think my critics, infra, are largely right.   I'll let the original post stand, so as not to be seen as hiding anything.  But see the comments below.]

Every so often I read something in a field I know something about that seems so wildly, flatly, gobsmackingly wrong that I figure I must be missing something [update: yes, I think I was].  Today is one of these days.

Here's a paper over at Vox EU, a website which calls itself "Research-based policy analysis and commentary from leading economists."  The title of the post is "Is the US bankruptcy code to blame for overinvestment in housing by US households?"  You can tell where this one is going--the answer to the question posed will be "yes."  But are you ready for this:
At the same time, the legal system favours homeowners who experience financial difficulties by making investments in home equity partially exempt from personal bankruptcy.
People--especially my bankruptcy buddies--help me out here.  Isn't this just a dumb-as-pig-iron schoolboy howler?  When they say "investments in home equity," I assume they are talking about mortgage debt, secured debt, yes?  [In context, I think this must be what they have in mind--and does anyone intentionally ever make an unsecured loan in home equity?]   But repeat after me: the homestead exemption is not good against mortgage debt.   You can't claim it, you can't rely on it,  In Sam Goldwyn's two words, ir-relevant.   So the homestead exemption can have nothing to do with "investment in home equity."

Citing other research, the authors also declare that "the homestead exemption increases the supply of housing credit [and] biases household investment towards home equity."  Huh?  They are saying that home owners borrow more because they enjoy exemption protection?  But even if they did enjoy exemption protection (they don't) --wouldn't we have to assume that the lender, too, knows about the homestead right?  Are they really telling us that the lenders stand mesmerized before the predatory borrowers and agree to lend the money even though they know they will have no right to get it back?  If this is truly their finding, don't they owe us just a hint of a surmise as to what would cause such bizarre behavior?

I'm really not sure where the authors got a screwed-up notion about the nature of the home equity exemption; it might have come from Rajan and Zingales in this book, where  R  and J make the same crude blunder.  I tried to demolish R and J's error here, but I guess rust never sleeps.

A final thought: I just noticed that all four co-authors seem to be associated with European institutions.  That might explain their utter ignorance of American law.  And does it suggest that in Europe I can protect against a mortgage with a homestead exemption?  Where do I sign up?
I notice at least one more crude misunderstanding; although it is less important it does provide additional evidence as to just how unencumbered by actual knowledge this piece is.  They say:
The US bankruptcy exemption for home equity, or homestead exemption, ranges from $0 in Maryland to an unlimited amount in eight US states, including Florida and Texas, in 2006.
Any first-semester bankruptcy student can tell you they  are stepping on their own shirttails here.  In fact, there are two separate exemption systems--"bankruptcy" and "state."  Any debtor always has his state exemptions (zero to infinity as the authors correctly state).  The Bankruptcy Code says that the debtor in bankruptcy may instead choose a set of "bankruptcy" exemptions--but the Bankruptcy Code also allows individual states to opt out of the bankruptcy system; in fact about three quarters of all states have opted out.   FWIW, the current "bankruptcy exemption" is $21,625,sometimes $22,775,


Anonymous said...

Yes, but is the schoolboy howler yours or theirs?
Mostly commonly, surely people say "home equity" meaning one's ownership stake in the home; i.e. precisely NOT any mortgage debt. Perhaps this as in ambiguous term, though I've never ever heard it to refer to anything other than the value in ones house _other_ than mortgage debt (i.e. it is the current value of house MINUS debt).

The authors you criticize seem to be using it with the meaning I am familiar with, at least as I would read it.:

> At the same time, the legal system favours homeowners who experience financial difficulties by making investments in home equity partially exempt from personal bankruptcy.

Investments = getting a mortgage? That make no sense.

> Households that file for bankruptcy according to Chapter 7 of the US bankruptcy code can retain the equity in their home up to a certain amount, determined at the US state level.

Can retain the amount mortaged as equity? What does that even mean?

> The possibility of declaring bankruptcy itself, and the retention of some wealth in bankruptcy

The last should be the least ambigious: you can retain wealth by putting equity (in theirs and my sense) into your home, i.e. by putting your own money into a house (larger downpayment, pay down the mortgage) - and thus slightly protect that amount invested to some extent more other investment options allow.
Getting a mortage (a second mortage, say) is giving up home equity, not increasing it.

Ebenezer Scrooge said...

I tend to agree with anonymous here. But I wanted to make a different point. In my legal practice, I deal with economists all the time. They all think that legal rules are very very important, but their knowledge of legal rules tends to be very very sketchy. Were these EU folk lawyers or economists?

(I've also dealt with EU lawyers--the good ones have a decent working knowledge of the US system.)

Buce said...

On sober reconsideration, I think my critics are right. I think I did misread: I concede that the authors are talking about the homeowners' investment, not the investment of others in the homeowner (as I had previously misread it).

I'm not sure the discussion ends there, however. The question would remain: exactly what do the authors mean by "overinvestment?" Here is the reading I can think of: they are saying that homeowners deploy their (finite) pool of resources to buy homes because home equity is exempt rather than to pay other bills. I don't think this is best understood as an "overinvestment" in homes per se, so much as an "underinvestment" in paying your bills. After all, you'd get the same result if the debtor spent all his money on consumables--booze and fine food. So the complaint is not what they do spend it on but what they don't.

Is it true, then, that debtors tank up on homes at the expense of competing creditors? I suspect the most helpful test would be a comparison of behavior in states with different exemptions. Do we see different behavior in, say, Maryland (with a zero exemption) and, say, Kansas (where I believe the homestead is most generous).I doubt it.

Still, on the central point, I believe did indeed misread them and I herewith apologize for my error.

Ebenezer Scrooge said...

In response to our host's last point, I remember some study that purported to show that a change to home exemptions in Minnesota caused exactly the predicted changes. I wish I could be more helpful with the particulars.

This may be an argument against exemptions, but I think it is a weak one, easily trumped by the "fresh start" policy of the Code.

Adam Levitin said...

Jack, I think you should hold your ground here. This study is remarkably silly and is another example of the disasters that can result when economists study legal regimes that they do not understand.

On a theoretical level, it's possible to imagine that homestead exemptions encouraged an overinvestment in homes rather than in other assets as a way to protect assets from unsecured creditors. But one can cede that point and still think that this study is chock full o' problems.

For starters, the problem with the housing bubble wasn't overinvestment in homes, but overleverage. The housing bubble was marked by declining investment in homes--downpayment fell, while LTVs rose. While this was sort of margin investing in housing, it means that homeowners weren't taking advantage of homestead exemptions. What's more, the study stops just when the bubble was getting going and the bubble soared after the BAPCPA enacted 522(p), which severely limited the homestead exemption.

But putting all this aside, the homestead exemption would only encourage investment in housing rather than other assets to the extent of one's dischargeable, unsecured debt. Thus, the issue is not the size of the exemption (what was studied), but the size of the exemption minus unsecured, dischargeable debt (which wasn't studied). For most households, that's pretty limited: credit card debt, some torts, auto loan deficiencies, other sundry claims. Not student loan or tax debt in most cases. I'm guessing that's typically less than $50k in debt. So at most the exemption encourages overinvestment in housing to the tune of $50k. That's nothing to sneeze at, but I think we have to discount that $50k heavily for the perceived unlikelihood of bankruptcy (or other collection actions) and ignorance of the law.

There are lots of other silly problems with this study, such as assuming that homeownership rates of Chapter 7 bankruptcy filers track those of the general population and not controlling for things like property taxes (which often vary by county or municipality, so they aren't covered by state fixed effects).

So stand firm and resolute here.