The macroeconomic case for principal reduction

Three Federal Reserve economists describe the case for principal reduction as follows:

The idea that a program to reduce principal balances on mortgage loans will cure the nation’s housing ills at little or no cost has been kicking around since the very early stages of the foreclosure crisis and refuses to die. … Why do so many wonks love principal reduction? Because they think principal reduction prevents foreclosures at no cost to anyone—not taxpayers, not banks, not shareholders, not borrowers.  It is the quintessential win-win or even win-win-win solution.

The logic of principal reduction is that in a foreclosure, a lender recovers at most the value of the house in question and typically far less. … In contrast, reducing the principal balance to equal the value of the house guarantees the lender at least the value of the house because the borrower now has positive equity and research shows that borrowers with positive equity don’t default. … Lenders could reduce principal and increase profits!

These economists assume that the argument in favor of principal reduction is founded on microeconomic principals — a search for the trade that creates the greatest economic surplus.  And, thus, they “disprove” the argument by questioning whether principal reduction is profitable for the lenders.

The problem with the principal reduction argument is that it hinges on a crucial assumption: that all borrowers with negative equity will default on their mortgages.  … in this simple example, the lender will obtain more money by choosing to forgo principal reduction.  The obvious response is that the optimal policy should be to offer principal reduction to [the borrower who will default on the mortgage] and not the other.

In fact, the strongest arguments in favor of principal reduction do not rely on the assumption that everybody wins.  Here are three such arguments.

(i)  The concept that mortgage debt should not be written down as a matter of course depends on specific view of debt.  The basic question that arises when one discusses “debt” is:  Is a promise to pay a fixed sum of money absolute or is it negotiable?

In general in the context of the modern American economy, the conclusion is that the debt becomes negotiable when the borrower declares bankruptcy.  Thus, United Airlines and a variety of other businesses have been able to discard their pension plans without liquidating the business and distributing a fair share of assets to the pensioners.  Similarly if a corporation has a mortgage, the “cram down” provision in Chapter 11 allows the bankruptcy court to write the amount of the debt owed down to the value of the property.  In fact, “cram down” exists in personal bankruptcy law as well — but there is one exception to it:  primary residences.

Thus, the basic principal on which the American economy functions is that debt has an element of negotiability.  One almost always has the right to threaten to declare bankruptcy and then force the creditor to write the debt down closer to its fair market value.  It doesn’t take very sophisticated economic analysis to understand that this property of the American economy helps reduce the likelihood of asset price bubbles, since it gives creditors a strong incentive to lend no more than the property is likely to be worth over the life of the loan.

While it is true that primary residences are excepted from cramdown, this doesn’t really explain why the American understanding of debt should differ just because that debt relates to a primary residence.  Obviously it’s in corporate interests to treat corporate debts as negotiable and consumer debts as absolute, but I suspect that it would be close to impossible to find a rational justification for such treatment of consumers as second class citizens.

(ii)  Moral hazard for financial institutions is created when loans against assets are protected from being marked down to their market value.   If banks are allowed to profit from their role in creating an asset price bubble in housing, then they are not discouraged from repeating the same behavior.  Thus, banks need to lose money on these underwater mortgages, or they will face incentives to be careless about lending against overinflated housing values and will promote housing bubbles again in the future.

(iii)  Most importantly, however, principal reductions are probably necessary for economic recovery.  A borrower whose house is worth 50% of the loan and gets a standard HAMP modification will, typically, (1) within eight years face a 33% increase in mortgage payments that were already set at the boundary of affordability and (2) not be in positive equity territory for 20-25 years (recall that a standard HAMP modification is not fully amortizing over 30 years).  In other words these are borrowers who are at high risk of default for the next quarter century.

The simplistic “will he or won’t he” analysis presented by the Federal Reserve economists failures to capture the nature of the housing market where “will he or won’t he” needs to be asked in every period until the loan is fully paid off.  Laurie Goodman (the report is not available on line as far as I now, but a report on a lecture using similar data is available here) has done this analysis and concluded that principal reduction is necessary to reduce the number of future defaults.

Our current housing policy is likely to prolong the experience of housing market default across a decade or even longer.  Those who support principal reduction are concerned that the economy will not recover until the constant influx of foreclosed homes onto the market slows.  There are two surefire ways of achieving this end:  the first is a general inflation that will pull house prices along with it and the other is a massive reduction in principal balances that will enable the vast majority of those who cannot afford to pay their mortgages to choose to sell their homes.

Of course, principal reductions are not costless — they are designed to place a fair share of the costs of a housing bubble on financial institutions.  Principal reductions are, however, almost certainly less costly than attempting to push most of the costs of a housing bubble that was inflated by under-regulated out-of-control financial institutions onto middle class consumers, whom economists are imagining will one day soon have the financial wherewithal to support a growing economy.

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