It looks like the term “Great Contraction” is taking off to describe the debt overhang problems in the economy. Here’s Kenneth Rogoff with a commentary piece titled The Second Great Contraction:
The phrase “Great Recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold…But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation…
If governments that retain strong credit ratings are to spend scarce resources effectively, the most effective approach is to catalyze debt workouts and reductions.
For example, governments could facilitate the write-down of mortgages in exchange for a share of any future home-price appreciation…In my December 2008 column, I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years.
Rogoff’s co-author, Carmen Reinhart, argues this point as well as the same policy recommendations: “A restructuring of U.S. household debt, including debt forgiveness for low-income Americans, would be most effective in speeding economic growth.”
And it seems like more and more people are starting to look at these arguments about a bad debt hangover, especially in the consumer housing market, and subsequent balance-sheet effects as drivers of our problems (see Ezra Klein, David Frum). And the evidence is convincing. Here’s Atif Mian and Amir Sufi on the link between leverage and employment growth:
If you take this analysis as an important part of what is going on, what should you conclude about the administration’s signature program on housing, the Home Affordability Modification Program (HAMP)?
Let’s start with two facts about HAMP that are relevant for the macroeconomy: First, it leaves the recently created mortgage servicing industry intact and in the driver’s seat of this crucial consumer debt market, while “nudging” them to be more open to modifications and resisting bad incentives. Second, HAMP also has a shockingly high debt-to-income ratio for its participants as well as a very high re-default rate. Both of these are disasters from a Great Contraction point of view.
What does it mean to leave the servicing industry in the driver’s seat? Let’s copy this table and use the analysis from the National Consumer Law Center’s Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior, by Diane E. Thompson:
Structured servicer fees (like late fees and foreclosure fees) create an incentive to keep a borrower in default. The servicer’s monthly servicing fee, computed as a percent of the outstanding balance, creates an incentive where servicers benefit from any and all delays in reduction of principal and suffer a permanent loss of income when they agree to a principal reduction. Loan modifications that increase principal by capitalizing arrears and fees give a boost to these fees. (It won’t surprise you that 70% of mortgage modifications fall into this category of increasing principals by capitalizing arrears and fees.) This structure gives servicers a huge incentive to do make-work modifications, ineffectual interest-rate adjustments and principal forbearance, because even though the monthly payment might be a bit lower the principal is the same and their servicing fee comes off the top (before the interest payment to bondholders).
Or in English, the servicing model has every incentive to pile on more bad-debts-as-principal even if it ends up making the mortgage higher risk. Modifications can leave a homeowner more underwater and more at risk, when we need modifications to find a path to solvency and a steady household balance sheet. Leaving servicers in charge, instead of moving this system to our excellent bankruptcy courts, is asking for underwater principal to actually increase, the exact opposite of what we need it to do under a Great Contraction.
Worse, HAMP has a horrible redefault rate. From the Congressional Oversight Panel report, A Review of Treasury’s Foreclosure Prevention Programs, page 96:
First, 21% of HAMP permanent modifications have redefaulted in their first year. That’s ghastly given that HAMP permanent modifications have an additional 3 months of trial seasoning and fairly serious payment reductions. The fact that Treasury hasn’t been reporting on this itself, much less analyzing the reasons for the redefaults is disgraceful….
The risk factors for HAMP permanent modifications are not front-loaded. A front-loaded risk would be unaffordable monthly payments. HAMP does a reasonable job on lowering monthly payments. But HAMP permanent modifications have high negative equity, balloon payments, interest rates that will rise over time (often from 2% to 5%, meaning a significant monthly payment increase), and high back-end debt-to-income ratios. These are all time bombs…
People who go through HAMP have absurd debt-to-income ratios; last year the median back-end DTI was in the range of 77%. No wonder consumption is lagging; there’s numerous people whose productive labors are essentially shackled to a bad debt load.
From an ethical point of view a re-default rate this high is an abomination. Consumer advocates talk about predatory lending as “equity stripping” and a modification that ends in a redefault should be thought of as “wealth stripping.” It keeps consumers running through costly hoops to end up no better off at all, so banks can juke their books on what properties are in what kind of shape.
But from a macroeconomic point of view, shouldn’t foreclosures be a good thing? Foreclosures aren’t costless – debtors prisons are making a comeback – but in abstract, shouldn’t foreclosures do the trick of deleveraging consumers and fixing the economy?
Maybe in a perfect market. However a simple macroeconomic principal should be to not force firesales into a depressed market where holders of similar assets are already highly leveraged and fire sales can cause balance sheet feedback. Especially when there is a positive correlation of distress between buyers and sellers of a good – say 9%+ unemployment – then assets will sell at a discount relative to value (and we see LGD of over 50% in housing right now) which will have spillover effects.
In the long-run the “liquidate the homeowners!” policy might work fine. But you know what Keynes said about the long-run….
So right now the status quo in the housing market is servicers piling on bad debt and keeping consumers in a risky limbo, modifications that result in massive debt-to-income burdens and eventual re-defaults anyway, and a system of runaway foreclosures that destabilize neighborhoods and create uncertainty among other homeowners and investors. HAMP took this broken servicer model and doubled-down on it by thinking some money could
bribe nudge this system to function. It hasn’t. All in all, a complete disaster from the Great Contraction point of view.