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.


8 thoughts on “The macroeconomic case for principal reduction”

  1. Why does it have to be one or the other and one-size-fits-all, and who is supposed to decide? Principal-reduction is one tool, foreclosure is another. How about creditors use whichever they see as more appropriate to the situation till the market clears.

    Which, by the way, why are we so afraid of foreclosures? It may be that in many if not most cases, principal-reduction is a better (for the banks!) solution than foreclosure. But why is ‘avoiding foreclosures’ a goal in and of itself? One way to get the influx of foreclosed homes to slow is to get them over with as fast as possible, and then clear the subsequent pipeline.

    And let’s not sugar-coat the costs of principal-reduction. You mention, and almost define, moral hazard as if you think it cannot apply to individuals. But if principal-reduction is seen to be “the” solution then there is huge moral hazard involved, and you should acknowledge this.

    Basically, a cohort of my peers “bought” more house than they could actually afford; if they are all now going to have their principal reduced, so they can keep the house they “bought”, and I pay higher interest rates as a result, how is that fair? (You say the costs will be pushed onto ‘financial institutions’, but that doesn’t actually happen, what happens is that interest-rates go up.)

    So on this round-trip I will have been forced to chip in to help finance other people, many of whom work less hard and make less money than I do, to buy McMansions. Also I’m a sucker for bidding full price for a house, and then keeping current on the mortgage. Actually generally, I feel like a sucker already for having a job, for believing in the social contract, generally for doing the right thing. If you can’t see moral hazard here then something is wrong. Also might that have ramifications for social cohesion? I think it might. Actually I am here to tell you it will.

    Finally, there is the credibility issue of a government that through one side of its face tries to get banks to lend as easily/loosely as possible, then through the other side takes the view that financial institutions…lent too loosely.

    Overall, this looks to me like a con job: use political power to favor loose lending, wait for the bubble, then ‘punish banks’ (i.e. middle-class people, through interest-rates and less-easy lending, as well as higher taxes to pay for bailouts) for doing it. Why don’t you just cut out the middle-man and rob me directly? I guess because that would not have the academic veneer of the “economics” seal of approval.

  2. I think you missed the point of my post which was to present the strongest arguments in favor of principal reduction. You don’t even reference the macroeconomic argument in favor of principal reduction, which is that it is a necessary change in order for the economy to recover: working through a decade or more of foreclosures (remember the banks don’t have the staff to do this with any speed and their modifications prolong the crisis rather than resolve it) is a recipe for a prolonged economic slump.

    In fact, your approach is purely microeconomic How about creditors use whichever they see as more appropriate to the situation till the market clears. The point of my post is that if we continue along the current path, the clearing of the housing market will take years as we wait for all the foreclosures to take place.

    I didn’t mention the moral hazard for borrowers issue, because it’s not relevant to the focus of this post, has been beaten dead in the press and in fact in the article that I linked to. I don’t see any need to restate it — especially since I have yet to see a treatment of the moral hazard of borrowers that makes any effort to weight the moral hazard of borrowers against the moral hazard of lenders. Since the lenders are the ones who are likely to determine what goes on in the next lending “bubble,” I would tend to put more weight on the effects of getting their incentives right. But I would be happy just to see a serious discussion of the complex moral hazard issues that the housing bubble has generated in the blogosphere/press.

    Presumably you also felt “robbed” and saw the end of “social cohesion” when United Airlines defaulted on its pension. Such socially disruptive events take place and the world moves on.

    [Edited for tone.]

    1. I agreed that working through the foreclosure pipeline is necessary for recovery, my point is that this could mean principal-writedowns but it can also just mean faster foreclosures.

      There’s no a priori reason that foreclosures have to take “years”. It is deliberate government policy that causes them to take so long. How much “staff” a bank should need to process a foreclosure on paper they hold is surely dependent on how many hoops the government makes them jump through, how many lawsuits they have to fight off to do it, etc. Why on earth doesn’t it take 15 minutes? “We bought the house for them and they haven’t paid us back.” “Ok, take the house.”

      So, if you want the pipeline cleared faster, you could equally well advocate for government to allow for a quicker/easier foreclosure process – it follows from your exact same “macroeconomic” reasoning. You do not, so I did.

      Not sure I understand your closing statement; it’s not obvious to me how United Airlines defaulting on its pension would have raised my taxes…United Airlines is not the government. I guess I just don’t see the fate of a private company, bad as it undoubtedly was for those affected, as having the same sort of social ramifications as does forcible government policy that effectively robs from Peter to…buy Paul a McMansion.

      1. There’s no a priori reason that foreclosures have to take “years”. It is deliberate government policy that causes them to take so long. The main reason foreclosures are taking as long as they are is that banks are not starting the foreclosure process on people who are seriously delinquent. At our July 4th party today it seemed as though everybody knows of somebody who has lived in their house for two years without paying a penny and without any indication from the bank that a foreclosure is coming. That has nothing to do with government policy and I live in a non-judicial foreclosure state.

        Why on earth doesn’t it take 15 minutes? “We bought the house for them and they haven’t paid us back.” “Ok, take the house.” Property law may be inconvenient, but it’s not really government policy. It’s more like a foundation of Anglo-American economic development. See Hernando De Soto for more on this issue. Making ownership of real property secure enough that it is reliable collateral for a loan requires legal “hoops.” Unfortunately the only alternative is disputed and disputable title.

        While the variety of foreclosure law across the US means that there are indubitably some states with foreclosure processes that can be improved without harming the quality of title, foreclosure law is far too complex to make a general statement that the solution is a quicker/easier foreclosure process. Quite a few states have a quick/easy foreclosure process.

        Re the closing. First of all it’s your taxes that will have to bail out the PBGC when it finally goes bust taking over the pensions of United Airlines’s brethren and secondly, as someone who sounds like you have a job with a pension, the precedent set by United Airlines represents a “government policy” that may one day “rob” you too. In fact, it seems likely to have a much more direct effect on you than your neighbor receiving a $100,000 writedown on his/her mortgage.

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