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?
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.