Why claims that the 2008 bailout was a “success” should make you angry

In 2008 we needed a bailout – or at least significant government/central bank intervention – but the bailout we got was unfair and almost certainly hampered the recovery. Furthermore, claims that “the bailout made money in the end” need to address the actual structure of the bailout.

So let’s talk about how the 2008-10 bailout of mortgage-related securities and instruments was structured. I focus on the mortgage-related bailout, because even when you’re talking about much more complicated instruments like CDOs, a lot of the trouble came from the outrageous practices that had been going on for the last few years in the US mortgage market. Here I’m not going to get into how the various instruments were related to mortgages, I’m just going to break down how the US used government funds to bail out the issuers and investors in private housing market-related instruments. There were three steps.

STEP 1: The Fed provided temporary assistance by supporting asset prices from March 2008 through February 2010 by accepting just about everything as collateral at the TSLF and PDCF and thus preventing fire sales of assets. The Fed also wrote supervisory letters granting bank holding companies (BHCs) the right to exceed normal limits on aid from the FDIC-insured bank to the investment bank, so that a lot of support of these asset markets took place on the balance sheets of the BHCs.

STEP 2: Many of the mortgages underlying the troubled assets were refinanced with the support of government guarantees against credit risk. The process of refinancing a mortgage requires the existing mortgage to be paid off in full. Thus, these refis had the effect of transferring poorly originated mortgages out of private portfolios and into government insured portfolios. This would not be a problem if the government insured mortgages were carefully originated, but that would not have solved the private sector’s problem, so that’s not what happened. Step 2 required both immense purchases by the government of mortgage backed securities and a simultaneously massive expansion in insurance offered for riskier loans.

1.  Massive purchases of GSE MBS.
The goals were to make sure the GSEs could continue to be active in the mortgage market, to drive down the 30 year mortgage rate to facilitate refinancing as well as purchases, and to raise the price of housing.

a. On Sept 7 2008 when Fannie Mae and Freddie Mac were put into conservatorship, Treasury also announced plan to purchase MBS securities. Apparently this program only ever reached about $200 billion in size (Sigtarp Report July 2010 136). Soon it was superseded by:

b. The Federal Reserve’s QE1: In November 2008 the Federal Reserve announced a massive program of supporting mortgage markets by buying mortgage backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. This purchase program ended up buying $1.25 trillion in MBS and continued until February 2010.

  • By the end of 2008 the 30 year fixed mortgage rate had fallen by a full percentage point. and would only decline further in later years.


  • Private sector MBS issues had declined to almost nothing by mid 2008 and even GSE MBS issues had dropped over the course of 2008. In 2009 GSE MBS came roaring back so that by mid-2009 monthly MBS issues were almost as high as they had ever been. The fact that in several months Fed purchases in the form of QE1 exceeded GSE MBS issues undoubtedly played a role in this dramatic recovery of the MBS market.

2008 Housing mkt
from “Charting the Financial Crisis” by Brookings & Yale SOM

2.   FHA insurance grew to account for almost 1/3 of the mortgage market.
From mid-2009 to mid-2010 alone FHA and GNMA insured loans increased by $500 billion (Sigtarp Report July 2010 p. 119).

FHA insured loans became a growing and then significant portion of the mortgage market after the major subprime lenders collapsed in early 2007, and FHA became the only choice for borrowers who couldn’t put down much of a down payment. Prior to the crisis FHA loans accounted for as little as 3% of the market. By June 2009 FHA loans accounted for 30% of the market and would continue to do so for several years. (See Golobay 2009 and Berry 2011a.)

By mid-2011 all the major banks held billions in FHA insured loans that were 90 days or more past due: BoA $20 billion, WFC $14 billion, JPM $10 billion, Citi $5 billion. Eventually every major bank would end up settling lawsuits over misrepresentations in FHA insurance applications. In the meanwhile they were using FHA insurance as a cover to avoid taking writedowns on the loans. (See Berry 2011b.)

Here is the FHA’s 2015 report on how the loans it guarantees have been performing. Note that the FHA insured $73 billion single family mortgages in FY 2006, $84 billion in FY 2007, $205 billion in FY 2008 and $365 billion in FY 2009 (see Table 1 here.)

FHA loan performance
(Note that the decision to separate fiscal year 2009 into first half (October 2008 to March 2009) and second half (April 2009 to September 2009) appears to be a genuine effort to show how different the two cohorts are, and as far as I can tell should not be interpreted as questionable data manipulation.)<\small>

3. Expansion of loans eligible for securitization by Fannie Mae and Freddie Mac by increasing the conforming loan limit to $729,750 in high cost states (which lasted until 10-1-2011).

  • The Special Inspector General for the Troubled Asset Relief Program concluded that the government had adopted an explicit policy of supporting housing market prices (SIGTARP report Jan 2010 p. 126). These programs stopped the decline in house prices nationally (the yellow line in the chart below) for the year 2009 and slowed the drop in house prices thereafter. As a result, nationally the bottom in housing prices wasn’t reached until January 2012. This meant that the massive 2009 government guaranteed refinancing of mortgages was deliberately executed at higher than market prices.

CR Case Shiller Index

Before going on to Step 3, let’s pause for a moment to get a good picture of what is going on here. By late 2008, it had become abundantly clear that Private Label Securitization was a shitshow. Tanta, who had 20-odd years of mortgage industry experience and spent the months before her death blogging at Calculated Risk, put it well in a July 2007 blogpost :

“we as an industry have known how to prevent a lot of fraud for a long time; we just didn’t do it. It costs too much, and too many bonuses were at stake to carve out the percent of loan production it would take to get a handle on fraud. The only thing that got anybody’s attention, finally, was a flood of repurchase demands on radioactive EPD [early payment default, i.e. 3 missed payments in first 6 months of loan] loans and other violations of reps and warranties. If [you] want[] to accomplish something, I’d suggest [you] … start slapping some issuers around on their pre-purchase or pre-securitization quality control and due diligence.”

So what was going on in 2007 and 2008 is that the market was recognizing that the “Non-Agency MBS” in the chart below was going to perform very badly, because it was so full of loans that should never have been made.

collapse of PLMBS
In many cases the originators who were theoretically on the hook for the reps and warranties they had made when they sold the loans to Wall Street had been driven into bankruptcy by – you guessed it – claims based on their reps and warranties. The bag they had in theory been holding had most definitely been passed on to someone else, but it wasn’t clear yet to whom. The obvious candidate was the issuers who had packaged these loans – with utterly inadequate due diligence – into securities for investors to buy. The catch was that the issuers were all the big banks: Bank of America, JP Morgan Chase, Citibank, Goldman Sachs, etc.

And we had financial regulators who were like deer in the headlights, transfixed by terror, when they heard that one of the big retail banks might be in danger. These regulators threw themselves headlong into the project of rescuing the big banks from their failure to perform the due diligence necessary to issue mortgage-backed securities according to the terms in their securities documentation. While I suspect that Ben Bernanke never quite wrapped his head around these issues (he had plenty of other things to worry about), it seems fairly clear that Hank Paulson and Timothy Geithner worked consciously to “save the financial system” by hiving loans that should never have been made off onto the Government. Geithner, in particular, would almost certainly claim that this was the right thing to do in the interests of financial stability.[1]

Thus, the mortgage sector bailout was designed so that the mortgages underlying the private label mortgage backed securities (PLMBS), the bulk of which had been made at the peak of the bubble, would be refinanced out of the PLMBS securities as quickly as possible. The private sector had no interest in financing such an endeavor itself, so the only way to do it was through the government sponsored entities.

By engineering a drop in the 30 year mortgage rate (the announcement of QE1 was apparently enough to do this), an incentive was created for mortgagors to refinance their loans. The same Fed program ensured that Fannie Mae, Freddie Mac, and Ginnie Mae would have no problem getting the funds to buy the refinanced mortgages. There was only one catch, a nontrivial segment of the PLMBS mortgages were not of a quality that could be sold to Fannie and Freddie – and the same would be true of any refis of those mortgages. That’s where the FHA comes in: by guaranteeing 30% of all mortgages in the crucial years 2009-2010, the FHA provided a way for some of the more dubious mortgages in the PLMBS to be refinanced and be paid in full. FHA loans are typically securitized by Ginnie Mae and may also be held on a bank’s balance sheet. The PLMBS loans that were paid in full – due solely to the presence of government guarantees in the mortgage market – almost certainly played a huge role in protecting the returns on the PLMBS, in reducing the losses to investors, and in reducing the liability of the issuers for their due diligence failures.

The key point to remember here is that there was nothing “market” about this whole process. The Fed was both providing the funds and driving down the interest rates, while a government backstop for the credit risk on the loans was provided by the GSEs. Multiple experts described the housing finance market as having been “nationalized” or put “on government life support” in this period.

Because of the degree to which the government took over the mortgage market in these crucial years, it becomes a little silly to focus on the fact that no money was lost (in aggregate) due to the government’s support of PLMBS and related assets. (As far as I can tell the costs included in bailout figures never include the losses that the GSEs incurred on the loans guaranteed from 2008Q4 to 2010Q4.) Overall it can hardly be a surprise that the government made money on the officially recognized bailout loans given that the government also took steps in to make sure that many of the underlying assets were paid off in full.

At this point you may be saying: Well okay, but given that the Fed and Treasury were successful in returning the banks to health and the GSEs are all doing okay now too, was there really any harm done by a few years of de facto nationalization of the housing market?

This is where Step 3 comes in. The whole scheme only works because of Step 3, and Step 3 is what has most of those who understand what happened absolutely smoking mad about the bailouts. The key to the PLMBS performing well was that the mortgages in them had to be paid off in full. In order for the existing mortgage to be paid in full, the refi that pays it off will have to be for the same amount as the existing mortgage or a little more.

STEP 3: No principal reduction for mortgage holders. It was essential to make sure that people who hold mortgages don’t have access to a program that allows principal to be reduced. Effectively, since the banks can’t be the bagholders because of the terror of financial instability and the government can’t just be handed the bag because that has very bad visuals, the public had to be made the bagholders. The only way to do this was to make sure the public was not cut any breaks.

1. Prevent cramdown legislation from being passed
Cramdown is how bankruptcy law treats collateral that has fallen in value below the value of the loan. If the debtor declares bankruptcy, the lender only has a security interest up to the value of the collateral and remainder of the loan is not treated as collateralized debt. An exception was written into the 1977 Bankruptcy Code excluding mortgages on primary residences from cramdown. (The claim at the time was that this would be better for borrowers. LOLWT[2].) In short, the bankruptcy code takes the position that finding a good solution to someone’s inability to pay debt requires recognizing the economic reality of the situation in virtually every case except for mortgages on primary residences.

Forcing lenders to come to the table on the basis of economic reality is something that every collateralized borrower can do – except for the little guy whose only collateralized loan is on his/her primary residence. Fixing the cramdown inequity was one of President Obama’s promises before he was elected. But lo and behold Treasury staffers in his administration “stressed the effects of cramdown on the nation’s biggest banks, which were still fragile. The banks’ books could take a beating if too many consumers [were] lured into bankruptcy by cramdown ” (Kiel & Pierce 2011). Treasury’s position on this should be read: we need to bail out the banks, so we can’t allow the economic reality of the situation to affect the cut that the banks get.

2. Failure to establish an effective principal reduction program until 2012
In July 2010 SIGTARP called Treasury out for its failure to establish an effective principal reduction program as part of its mortgage modification program (Sigtarp Report July 2010 174ff.) However, not until May 2011 had the Treasury been sufficiently shamed over the lack of principal reductions to begin reporting on the Principal Reduction Alternative (PRA) data. By May 2011 less than 5000 permanent modifications had been started that included principal reduction. This was less than 1% of the permanent modifications started under the HAMP program (MHA Report May 2011).

This delay was important, because if borrowers had been offered modifications with principal reduction in the crucial years from 2009-10, it undoubtedly would have affected decisions to refinance loans that had been made at the peak of the bubble. By May 2012 permanent modifications with PRA that had been started had jumped to 83,362 which was over 8% of all permanent modifications started (MHA Report May 2012).  More recent reports indicate that ultimately 17% of all permanent modifications started included principal reduction. (MHA Report 2017Q4 p. 4)

3. Failure of FHA short refinance program. In August 2010 the FHA established a short refinance program which imposed strict rules on lenders including 10% 1st lien principal writedowns.  A year later the program had helped only 246 borrowers, in part because Fannie and Freddie refused to participate, and the program was slated to be closed (Prior 2011).

So what’s my conclusion? Everybody who wants to tout the success of the bailout needs to tackle the reality of the bailout’s structure. There was a housing bubble. Somebody was going to have to absorb the losses that are created when lending takes place against overpriced assets.

Because in the name of financial stability the Fed and Treasury decided that banks weren’t going to bear any of the losses on the origination and securitization of bad mortgages, they had to find a way to put the tab to the government and to the public.

It was put to the government by putting the mortgage market on government life support from late 2008 to 2010, so that people would refinance out of the bad mortgages in PLMBS securitizations into FHA loans and into GSE MBS.

It was put to the public by making sure that their mortgages were not written down in value, even though the value of the house being used as collateral had collapsed. This means that the housing price bubble of 2006-07 is still with us today. It is being paid off by homeowners who are still paying these mortgages, who can’t spend that money on consumption, and who are scheduled to keep paying off bubble-level housing prices right up until 2050.

HH svgs
From Deutsche Bank via Tracy Alloway: https://twitter.com/tracyalloway/status/1040391962090590209

So when you see a chart like the one just above, which shows US consumers saving far more than predicted, you should recall that paying down mortgage principal counts as savings and a lightbulb should go off in your head. You should be thinking when you see this chart: “Aha. Look at all the US consumers who are still paying for the housing bubble. The 2008 crisis should have been handled differently.”

P.S. While we’re talking about anger and crisis housing policy let me offer two notes on HAMP modifications.

  1. Look at this chart from “Charting the Financial Crisis” by Brookings & Yale SOM (part of a project advised by Tim Geithner)

HAMP by count

They very carefully report the number of borrowers helped, but not the principal value of the mortgages before the modification and the principal value of the mortgage after the modification. Most HAMP modifications included significant increases in the principal borrowed, as not only interest accrued during trial modifications but also a variety of fees that borrows rarely understood or reviewed, were capitalized into the loans.

  1. In general the HAMP program is performing execrably as might have been expected given its design. (See here for details.) After 60 months the program increases the payments that were carefully set to the maximum the borrower can afford when the loan was made. The program may continue to increase payments each year for 2 to 3 years, that is, at 72 and 84 months. In short, the program was designed to give borrowers as little as possible: borrowers get five years respite in payments without reducing the present value of the modified loan on bank balance sheets. To avoid hitting bank balance sheets payments have to go up for the remaining 35 years of the loan. On pages 7 and 9 of the 2017Q4 MHA Report, the data on performance is very carefully presented only up to 60 months. One has to read the appendices – specifically Appendix 6 – to learn that for each vintage with 84 months of data at least 50% (and up to 65%) of loans have become delinquent.

[1] I have a draft paper in which I draw the analogy between Geithner and a couple of early 19th c. Bank of England directors who had been similarly traumatized by their early experiences dealing with financial crises and also advocated throwing money at them no matter what. The difference is that these two directors were lambasted by their contemporaries including Ricardo, and their claims have gone down in history as “answers that have become almost classical by their nonsense” (Bagehot 1873, p. 86).

[2] LOLWT = Laugh out loud with tears.


When can banks create their own capital?

A commenter directed me to an excellent article by Richard Werner comparing three different approaches to banking. The first two are commonly found in the economics literature, and the third is the credit creation theory of banking. Werner’s article provides a very good analysis of the three approaches, and weighs in heavily in favor of the credit creation theory.

Werner points out that when regulators use the wrong model, they inadvertently allow banks to do things that they should not be allowed to do. More precisely, Werner finds that when regulators try to impose capital constraints on banks without understanding how banks function, they leave open the possibility that the banks find a way to create capital “out of thin air,” which clearly is not the regulator’s intent.

In this post I want to point out that Werner does not give the best example of how banks can sometimes create their own capital. I offer two more examples of how banks created their own capital in the years leading up to the crisis.

1. The SIVs that blew up in 2007

You may remember Hank Paulson running around Europe in the early fall of 2007 trying to drum up support for something called the Master Liquidity Enhancement Conduit (MLEC) or more simply the Super-SIV. He was trying to address the problem that structured vehicles called SIVs were blowing up left, right, and center at the time.

These vehicles were essentially ways for banks to create capital.  Here’s how:

According to a Bear Stearns report at the time, 43% of the assets in the SIVs were bank debt, and commentators a the time make it clear that the kind of bank debt in the SIVs was a special kind of debt that was acceptable as capital for the purposes of bank capital requirements because of the strong rights given to the issuer to forgo making interest payments on the debt.

The liability side of a SIV was comprised of 4-6% equity and the rest senior liabilities, Medium Term Notes (MTNs) of a few years maturity and Commercial Paper (CP) that had to be refinanced every few months. Obviously SIVs had roll-over (or liquidity) risk, since their assets were much longer than their liabilities. The rating agencies addressed this roll-over risk by requiring the SIVs to have access to a liquidity facility provided by  a bank. More precisely the reason a SIV shadow bank was allowed to exist was because there was a highly rated traditional bank that had a contractual commitment to provide funds to the SIV on a same-day basis in the event that the liquidity risk was realized. Furthermore, triggers in the structured vehicle’s paperwork required it to go into wind down mode if, for example, the value of its assets fell below a certain threshold. All the SIVs breached their triggers in Fall 2007.

Those with an understanding of the credit creation theory of banking would recognize immediately that the “liquidity facility” provided by the traditional bank was a classic way for a bank to transform the SIV’s liabilities into monetary assets. That’s why money market funds and others seeking very liquid assets were willing to hold SIV CP and MTNs. In short, a basic understanding of an SIV asset and liability structure and of the banks’ relationship to it would have been a red flag to a regulator conversant with the credit creation theory that banks were literally creating their own capital.

2. The pre-2007 US Federal Home Loan Bank (FHLB) System

In the early naughties all of the FHLBs revised their capital plans. For someone with an understanding of the credit creation theory, these capital plans were clearly consistent with virtually unlimited finance of mortgages.

The FHLBs form a system with a single regulator and together offer a joint guarantee of all FHLB liabilities. The FHLB system is one of the “agencies” that can easily raise money at low cost on public debt markets. Each FHLB covers a specific region of the country and is cooperatively owned by its member banks. In 2007 every major bank in the US was a member of the FHLB system. As a result, FHLB debt was effectively guaranteed by the whole of the US banking system. Once again using the credit creation theory, we find that the bank guarantee converted FHLB liabilities into monetary assets.

The basic structure of the FHLBs support of the mortgage market was this (note that I will frequently use the past tense, because I haven’t looked up what the current capital structure is and believe that it has changed):

The FHLBs faced a 4% capital requirement on their loans. Using the Atlanta FHLB’s capital plan as an example, we find that whenever a member bank borrowed from the Atlanta FHL bank, it was required to increase its capital contribution by 4.5% of the loan. This guaranteed that the Atlanta FHL bank could never fall foul of its 4% capital requirement — and that there was a virtually unlimited supply of funds available to finance mortgages in the US.

The only constraint exercised by FHLBs on this system was that they would not lend for the full value of any mortgage. Agency MBS faced a 5% haircut, private label MBS faced a minimum 10% haircut, and individual mortgages faced higher haircuts.

In short, the FHLB system was designed to make it possible for the FHLBs to be lenders of last resort to mortgage lenders. As long as a member bank’s assets were mortgages that qualified for FHL bank loans, credit was available for a bank that was in trouble.

The system was designed in the 1930s — by people who understood the credit creation theory of banking — to deliberately exclude commercial banks which financed commercial activity and whose last-resort lender was the Federal Reserve. Only when the FIRRE Act in 1989 was passed subsequent to the Savings and Loan crisis were commercial banks permitted to become FHLB members.

From a credit creation theory perspective this major shift in US bank regulation ensured that the full credit creation capacity of the commercial banking system was united with the US mortgage lending system making it possible for the FHLBs to create their own capital and use it to provide virtually unlimited funds to finance mortgage lending in the US.


Missing the point on the “wages of sin”

Ryan Avent seeks to rebut Matt Klein on the issue of whether a popped real estate bubble must have adverse consequences on the economy as a whole. Afterall, as Avent points out the houses are built and in the worst case we can just let them rot and turn our efforts to gainful production. He “dreams of a day when the only people who suffer from money-losing investments are the money-losing investors.”

The problem with our reaction to the real estate bubble is that the “money-losing investors” haven’t lost their money (yet). The houses were built on debt and there are vast losses on that debt that have not yet been realized.  There’s no issue of morality here.  Someone has to take the losses.  It should have been the banks (who had vast exposure on second liens) and the mortgage investors. Instead, we’ve been protecting the financial sector by convincing people to continue making payments at bubble prices on their houses.  That’s the point of HAMP, the government modification program.

The “wages of sin” language is unfortunate, but the point that nothing good can come of prolonging the financial sector’s realization of its losses over a decade or more remains. The nature of debt means that losses must be realized — and this truth remains with or without moralistic framing.

Vast numbers of mortgagees still owe twice as much as their homes are worth are are continuing to make payments (in December 2012 30% of mortgagees in the crisis states were underwater, 4.7% of all mortgagees owed twice as much as their homes were worth) — in part because the payments have been temporarily reduced through HAMP and HAMP-like mods. These payments are going to support the banks and mortgage investors, who are currently accounting for these loans as though there are no losses (i.e. because payments are current). Instead of these individuals’ income being freed to circulate in the economy productively, this income is spent on preventing the realization of losses in the financial sector.

People who know economics generally assume that what is happening can’t happen, because it doesn’t make sense.  Any rational homeowner would walk away from a mortgage that’s the double the value of the home — and indeed sometime over the course of the 40 to 50 years that this debt is to be paid most likely the homeowners will choose to walk away. However, currently large chunks of U.S. income are being spent on preventing the realization of financial sector losses. I would say that it’s no coincidence that the overall economy is simultaneously remarkably weak.

Given how poorly our financial system is functioning when it comes to simply recognizing losses and moving on, Matt Klein may be right to ask: “Wouldn’t it be ironic if our unwillingness to punish reckless lenders for their sins crippled our economy for a generation?”

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.