H/T to Mark Thoma (who has covered similar ground). The Nobel-winning economist Vernon Smith has an editorial in Newsweek – Mired in Disequilibrium – about balance sheet recessions and how to get out of them:
…Some 23 percent of homeowners owe more than their home is worth on the market, and their demand for goods is restrained by the need to pay down debt. This is the essence of a balance-sheet recession, and is what underlies the so-called Keynesian liquidity trap….
There are three routes to restoring equilibrium:
• Inflate the prices of all other goods, including labor, while housing demand remains stuck in its negative equity loop. Fed policy has been consistent with this objective since 2008 with no evidence of success, as is typical in severe balance-sheet recessions.
• Allow the household deleveraging process to grind through an extended period of low GDP growth and high unemployment until we gradually recover. This option will surely succeed in due course, but not without high annual opportunity cost in terms of lost wealth creation. This was the path followed in the Depression.
• Do for households what the Fed sought for the banks: the Treasury (facilitated by Fed monetary ease and bank capital requirements) finances the banks to restate the principal on current negative-equity mortgage loans, restoring them to new mark-to-market zero-equity baselines.
The last option, in principle, seeks to reboot homeowners’ damaged balance sheets in an effort to arrest a prolonged deleveraging process and more quickly restore household demand to levels no longer dominated by negative home equity. It is analogous to a mortgage “margin call” with public funding of the restored household balance sheets.
I regard the third option as far better than the stimulus, while recognizing that forgiving debt—whether bank or household debt—is never good policy. But please keep in mind that we have had no good options.
This is similar to a March 2009 proposal in Slate by Eric Posner and Luigi Zingales that would take the hardest hit zip codes and reset their mortgage under the condition that the bank gets half the upside of any future appreciation.
These two plans sound like really complicated programs, large-enough in scale to be inefficient. Which is a waste, since we already have this great system for writing down and managing burdensome debt, and it’s this marvelous thing called our bankruptcy laws. Sadly there’s a defect in it that prevents bankruptcy courts from writing down single-family principle residence mortgage. Just so you know, the “cramdown” people knew that the foreclosures and the negative equity was going to ravage our economy for a decade like years ago.
We could easily pass a streamlined, modified version of bankruptcy just for this crisis. Adam Levitin has proposed this with his Chapter M for Mortgage bankruptcy. It would remove foreclosure actions from state court to federal bankruptcy court. Successful petitions can be offered a standardized pre-packaged bankruptcy plan. The plan would be based on HAMP modification guidelines (interest rate reduction to achieve 31% DTI goal, but without federal funding) plus cramdown to address negative equity.
We can make this fair on the backend. If the homeowner redefaults we can speed up the foreclosure process. It wouldn’t affect non-mortgage lenders. It is fast-tracked relative to traditional Chapter 13. It can have clawback mechanisms to address potential future appreciation.
And going through the process can give the lender clean title. Because there’s this whole issue of who owns what in the securitization chain which is a few court cases away from putting our financial system over a cliff. And the best feature is that it has no cost to the federal government. Like other smart policy, it builds off already existing infrastructure, so it can be started immediately using existing courts and Chapter 7 panel trustees for sales.
Why doesn’t this happen?
Real Talk
Vernon Smith is a libertarian. The general rule for libertarians and their approaches they have to re-regulating the financial system is that they need to be able to move at least a handful of Republicans. This has certainly been the dynamic over the past three years, particularly when it comes to Dodd-Frank. With all GOP votes playing Waterloo, fighting any type of accomplishment that Obama could pass and taking marching orders from the financial lobbyists, the median voter becomes Blue Dogs and New Democrats who are ultimately not going to do anything that threatens Wall Street. And the better libertarian ideas aren’t going to get anywhere.
One of the most consistent things about the energy of the Tea Party is their opposition to any interventions for suffering homeowners. As the Wall Street Journal reported, FreedomWorks was AstroTurfing anti-foreclosure relief with sites like AngryRenter back in March 2008. For all the talk about how the Tea Party is a group of populists who hate bailouts of Wall Street, the actual Santelli “Rant of the Year” was about HAMP, the ineffectual mortgage modification program, not TARP. He didn’t want to subsidize “the losers.”
Over the past three years, the Blue Dogs and new Democrats have shown no interest in anything like this. Matt Stoller called it in November 2007 when the bankrutpcy modification fight was in full force:
If you want to know why we haven’t heard much about the subprime mortgage mess from Democrats, it’s because there’s an intraparty fight brewing in the House of Representatives over what to do….the reason the subprime mortgage meltdown is so problematic is because homeowners can’t renegotiate mortgages for primary residences in bankruptcy court. If you declare bankruptcy, you still can’t get out from under your mortgage debt, which essentially enslaves people whose home value has dropped lower than their debt amount…
The good news is that Brad Miller, Linda T. Sánchez, Barney Frank, and Mel Watt have a bill in Congress that empowers bankruptcy courts to restructure mortgages for primary residences….It’s a very sane and reasonable approach that lets people declare bankruptcy and get our from under horrific levels of debt.
The interesting news is that 16 fellow Democrats are opposing this bill because it will impact the Bankruptcy Bill provisions they passed in 2005. Who are these lovely people? If you guessed ‘Blue Dogs’, you’d be right….
It’s time to understand that Bush Dogs are part of a working conservative majority. They are not our friends, they are not our allies, they are political opponents who want to bail out wealthy investors and hurt people trapped in subprime mortgage markets. Politically, they are also the people hurting Democratic capacity to differentiate ourselves as populists and capture swing areas and exurban Republicans hurt by the housing meltdown.
And here we are, with sky-high unemployment for the foreseeable future.
Rortybomb 
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Mike,
This is right on the money – with bonus points for tieing in the Santelli Rant, the launch vehicle for the Tea Party movement.
There are some very difficult knots to untie in this problem, and a big part of the issue is that (as far as I can see) the main technocratic thinking on the topic is coming from the Left, while the Right is mostly engaged in rallying around slogans (No More Bailouts!) and looking for the next Waterloo.
Greg Mankiw is one of the people I’d hope to see, coming from a right wing perspective, involved in crafting a technocratic solution which can get some kind of bipartisan support. But his work, with its emphasis on rewarding the deserving, sets up the kind of appeal to “morality” which will be a trap. It’s very easy for people who have jobs and pay their mortgages on time to feel that they are the righteous, while those who have fallen into financial distress have made poor choices and therefore deserve to suffer the consequences.
For many people (and their representatives), it’s the Ants vs the Grasshoppers. Add the incentives of banks to preserve their fragile balance sheets against any form of primary or second lien writedowns, and you have a strong coalition opposed to cramdown. I don’t have any answers to this, just a conviction that until the next stage of the crackup happens (maybe after those few court cases) we’re stuck with extend and pretend, and lots of sidelined workers.
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Well, as a renter who’s been ‘priced out forever’ I’m enraged at the moral hazard of plan 3. Without some seriously strong provisions in it to avoid giving any upside for future appreciation to the defaulter (no viable incarnations of which I can imagine), you are training generations of Americans to cheat as much as they can, with as much debt as they can, because Uncle Sam will bend over backwards to keep you in your home.
Instead, they need an appropriately priced mortgage – like 15% for risky things, so those who can’t afford 15% WON’T BUY, and the high default rate will be tolerable to the lenders, who can make their small banking profit and go home.
You are not a debt slave on an underwater mortgage unless you choose to be. Take 3 months free rent while you find a suitable place to rent you can afford, default, and move out. The lender can re-sell the home at market value, learn their lesson about how to price risky assets, and a new family can get that home at a non-inflated value and start to build equity. Like my family.
Oh yeah, I’m far Left on the political spectrum, but I don’t see why that matters for this discussion. I don’t like cheaters getting away with things, be they big banks or the little guy. If my neighbor is given a $200k cramdown, that is a $200k opportunity cost charged to my ‘account’ because I was reasonable and didn’t take out an option-arm I couldn’t afford next door to him! And you prop housing prices up which is NOT GOOD.
Can you stop proposing things that make this whole mess WORSE for me?
Sorry for using capital letters – please try to see this from my point of view.
These are excellent points. I’m in your position precisely.
Factoring in the mortgage tax deduction, which is incredibly regressive, might be enough to send people like you and me over the edge.
But the counterargument, which is pretty good, is that our economy is terrible because of the subprime mess; that our economy and the employment picture can’t improve until the balance-sheet recession is remedied; and it’s people like us that benefit from an improved economy.
These are debatable points, of course, but it would be foolish to ignore that proposals like these are intended not to help particular moral-hazard-prone individuals, but society in general, in the form of a humming economy that might grow the number of fat jobs for smart people who are currently “priced-out,” allowing them to feed themselves in the short-term and perhaps eventually consider homeownership.
The people who benefit most from a cramdown are the current mortgage holders. I’m not sure why a cramdown raises the economy. They will continue to struggle to pay their debts (even crammed down). I think bankruptcy is the solution – that’s how to get out from crushing debt. It’s rough for a while, but eventually you’ll be on your feet. Spend and save wisely, and in 7 years it’s wiped from your record!
Get those people out from under their debt load, and they can go back to spending what little disposable income they have on meaningful goods and services, instead of servicing debt on overpriced housing! Belief-based paper equity is not a meaningful resource for the US economy!
My other feeling is that cramdowns benefit big banks by propping up housing prices, so they don’t have to mark their assets down so much they go bankrupt. They should go bankrupt, too, and let a less greedy company earn the rents they’ve been stealing, at a fair but modest profit, with a decent risk-model. I don’t care if these cheating banks go under – I don’t want an economy based on their ‘product’ either – it’s unsustainable, and we’ll just be waiting for a new bubble and bust and bailout.
I’ll be happier with a slower growing, more stable economy based on production of meaningful goods and services (like a good auto mechanic and a solar-panel installer), with higher taxes paying for a decent education, decent healthcare, and reasonable public services. I won’t be looking to my house to appreciate beyond the CPI. It’s actually not too crazy…but we can’t get there by supporting the broken systems, and increasing the moral hazard that put them in place.
A. Lewis, a few points.
The issue is spillovers and uncertainty in housing from extensive REO inventory and cascading bankruptcies. If LTV is 150, so your mortgage is $150 for a $100 mortgage, it is likely the bank will have to mark down the property to < $70 (the recovery is very low), which hurts banks the most. There are reasons in the servicing infrastructure why this isn't happening.
If we can mark it down to $101, then it's a win-win-win. That actually won't help future homeowners; writing it down to $70 means you'll have to pick up that extra $30 with your mortgage rate. That's why the research leads me to believe cramdown won't actually impact future rates (Levitin has research on this).
What's the moral hazard? The moral hazard is on the banks if they don't have to take any pain for making stupid loans, and that the government will stand by while the economy crashes, gives emergency liquidity to the banks, etc. Yes rates will go up, but they'll go up anyway.
P.S. Love your blog, keep it up!
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I like my four point economic recovery plan better than anything I read above. But then, I don’t have a background in finance so what do I know.
http://wallstreetchange.blogspot.com/2010/11/2010-after-election-4-point-economic.html
My idea requires no bailout, no favors, treats main street fair and square, and it stands up to the billionaires, who are extending the planet’s pain because nobody will stand up to them.
As for re-defaults resulting in accelerated foreclosures, that seems out of touch to me.
There can only be an accelerated re-default if some of the original down payment is on the table for the homeowner to walk away with if they are foreclosed upon. The same applies to those with home equity built up in their home, but if they are out of work they cannot access those funds and can lose everything under the proposal above.
I can tell most of you never read anything I have written or simply feel above it, but you are wrong, and I am right. It’s really that simple, because the out of touch come up with educated plans thought up in rooms with other educated people who all live one economic strata. Your ideas can never be as good as people who live on main street and see reality from the ground floor.
Nobody has even mentioned that when family members caretake for a parent, they are basically screwed every which way, yet our president thinks he accomplished something with his healthcare plan.
As for position one in the article that the fed inflated prices, then how come Social Security payments have been frozen for two years now?
What I see missing here is the role of speculators (flippers et al.). I have seen no good data, but some estimate they were as much as 40% of the market in the worst locales – CA AZ NV FL. There must be rules and oversight to prevent them from benefitting from these schemes.
And weren’t those who bought just one home without a down payment really speculators, as A. Lewis implies? The default rate after writedowns is already disturbing; by definition these underwater “homeowners” have no down payments.
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