On the proposed first residence policy

Cyprus has been in the eye of the storm for a while now. An array of adverse shocks has hit the economy of the small island economy (a nice summary can be found in Zachariadis' analysis). Due to the severity and magnitude of both the liquidity shock and wealth effects, which ensued the "deposit-shares swap" (or as it has been wrongly dubbed "the haircut") and the resolution of Laiki took place, the government is worried about a surge in non-performing loans. What´s particular worrisome for the government is the possibility of home confiscations by banks as a response to mortgage defaults.

As a result, the government has put forward a policy that aims to address the problem of people ending up without a house. Specifically, if someone defaults on her mortgage (let`s call her the "defaulter"), then an can either buy or lease her mortgage contract/house from her bank (let`s call the owner of the contract, the "M.O."). The defaulter, however, has the right to live in the house (whose mortgage she defaulted on) as long as she is willing to pay a monthly rent to the M.O.. Moreover, the defaulter can, at a pre-decided point in the future, buy back her mortgage/house from the M.O. The buy-back price equals to the value of the mortgage (loan) when it was defaulted.

For example, suppose John had started off with a $100,000 mortgage and paid back 40% of it, but now decided to default. Then, an MO can buy his mortgage/house from John´s bank, but John can still live in his house as long as he pays rent. Moreover, at some point he can buy back his house so long he gives back the $60,000.

So, here is the key issue with the proposed policy that has also been a subject of some controversy among MPs; any amount John pays as rent is not intended to be used as mortgage repayment. In fact, a lot of people questioned the ability of the proposed policy to guarantee that no-one will end up homeless. At this point, I should also mention that the proposed policy plan is only concerned with the first home of each family. Hence, it does not protect homeowners from complete home confiscations of their second, or third etc., house.

In fact, this provision leads to some complexities that seems that have eluded most of our politicians. For instance, what defines a first home; if someone defaults on all his property, who decides which is one is his first home? And how is this decision being made?. These are some concerns that have not really received any attention, and unfortunately will not receive any here either.

My main focus is to address the concern about the payment of the rent mentioned above. Some have hinted at the immorality of making a house occupant pay rent for what used to be his house. Furthermore, people deem it unfair that the rent is not being used for mortgage repayment. Yet it is possible for the defaulters to benefit from this arrangement.

In order to illustrate this fact, let's introduce some notation so that we can do a bit of economics. Let "R" denote the monthly rent (assumed to be time invariant), while "Tmax" is the number of months an individual expects to live in a house, when she first moves in. It´s further assumed that an individual does not anticipate to ever move out, so Tmax essentially is the number of months an individual expects to live. "V0" is the value of the mortgage in period 0, and thus is the total amount that the individual has to pay back (for simplicity assume interest rate is 0). In such case, an individual who makes an average monthly payment of "P" towards her mortgage is expected to pay back the whole amount in "Y" years. That is, V0=P∙Y. Lastly, I assume no credit constraints in that an individual can borrow as much as she likes.

Given the above, in period 0 we cannot have Tmax∙R<P∙Y. To see this, suppose that we do. Then, an individual faces the following tradeoff. She could rent a house for all Tmax months, which will cost her Tmax∙R. Alternatively, she can buy a house worth V0 (assuming she borrow the whole value of the house). Then, she will have to pay back P∙Y. Clearly, the former dominates the latter, and hence no one would take up a mortgage. By a symmetric argument, it's obvious that we cannot have Tmax∙R>P∙Y, because if this was not the case, no one would be renting a house. So, if we want to derive an equilibrium in which we have both tenants and owner occupancy, we must have Tmax∙R=P∙Y.

If we solve for the average monthly mortgage instalment, we get

P = (R∙Tmax)/Y.

This formula enables the comparison between the average monthly mortgage payment (P) and rent (R). It's immediately apparent that P≥R when Tmax ≥Y. So, a natural question is whether Tmax ≥Y is a logical assumption to make. In fact, if we assume otherwise, then nobody would be a lender, because she would never receive her money back. This because Y represents the months it takes to repay the mortgage, while Tmax the maximum number of months an individual expects to live. Hence, lending money out would be mean that upon the death of the borrower, the lender would not have received all her money back. So, nobody would lend if Tmax <Y were not the case. Hence, we have Tmax ≥Y.

Consequently, we must have that P≥R; namely, that monthly rent is at most equal to the average monthly mortgage repayment. Hence, a defaulter will in fact observe a reduction in his monthly housing costs once his house is seized. Of course a defaulter will lose ownership, and will most likely have to move at some point to a new place. This will impose further costs, which are ignored in this simple analysis. Furthermore, one could argue that instead of forcing rent upon defaulters is suboptimal to an extension of Y.

These arguments, however, do not negate the fact that a defaulter will experience a decrease in her monthly housing fee. Moreover, observe that maximum value of Y is Tmax, and that if Y=Tmax, then the borrower  will simply die right after she gets full ownership of the house. In such a case, renting and "owning" a house are ultimately equivalent. If, instead,Y is increased but maintained below Tmax, then an individual can earn house ownership before she dies. However, given the equilibrium condition stipulates P = (R∙Tmax)/Y and Tmax ≥Y, then R will still be lower than P, and thus for a sufficiently impatient individual (i.e., sufficiently small discount factor), renting will still be superior.

All in all, should it be left to the market forces, then we would expect that the government`s proposed policy will enable the defaulters to swap the combination (renting, low housing fee) for (ownership, high housing fee). However, it conceivable to anticipate that the determination of the rent will not be decided by market forces, but will be instead capped by the state. Of course a rent fee cap only make senses, from the point of view of the state, if the cap is placed below the equilibrium rent fee. In other words, it is quite conceivable to expect that the rent paid by the defaulters will be well below the equilibrium rent, which in turn is less than the mortgage payment, as established above. Hence, the government´s proposed policy can greatly benefit defaulters.