The idea that what we are experiencing is a “balance sheet” recession, analogous to the Japanese recession in which companies undertook too much debt, continues to gain currency. In our instance it is households that have undertaken too much debt.
I’ve seen precious few ideas for dealing with this problem and most of the solutions I’ve seen either deal with problems that don’t have a great deal to do with excessive household debt or are oblique in the extreme. I wanted to float an idea I’ve been toying with for dealing with the problem.
One of the aspects of the huge overhang of household debt that doesn’t receive enough attention is that most of the household debt belongs to the highest quintile of income earners. I’ve published the supporting information on that particular factoid frequently enough and recently enough that I won’t bother going back and dredging it up again. Suffice it to say that if, magically, all of the household debt held by the three lowest income quintile were wiped out it would barely scratch total indebtedness.
I think we can agree that incentives are a non-starter. I can only imagine the outcry if President Obama, for example, were to announce a debt forgiveness program that concentrated on the debt that’s actually out there which belongs to the highest income quintile. Handouts to the rich, forsooth! And, as mentioned above, while debt forgiveness programs for the lower income quintiles might pass political muster they don’t hold enough debt to fix the collective household balance sheet.
The idea that I’ve been toying with has two components: disincentivizing the holding of debt and encouraging the sale of assets bought on time.
What I’m thinking about for the first component is to put a cap on the deductibility of mortgage interest. What I’m thinking about for the second component is debt forgiveness contingent on sale. That is, banks would be required to forgive the difference between principal remaining on a loan and the amount realized on sale. Banks might squeal but in doing this they’d lose little but bad loans and banks are, after all, creatures of the state. It would enable those who are underwater to walk away clean from an underwater loan and the first component, the cap on mortgage interest, would provide the incentive for doing so.
I haven’t worked out all of the details so I’m just floating a trial balloon. What do you think?
They’re always squealing about their taxes (around here, anyway). If the MID was capped, wouldn’t the squealing get turned up to 11? Could we do something like this (just spitballing)?
Reduce the marginal rates for the highest income earners in year 0 to some “reasonable” number. Continuance of the reduced rates in years following would be contingent on paying off debt with the tax savings accruing. (We could calculate the difference between taxes under the old and new regime. This would equate to tax savings to you.) If you don’t use your tax savings, or some significant portion thereof, to reduce your debt, it’s back to mere subsistence for you.
Would something like that work?
I think for the second component to work, you would need to create a procedure to regulate the sale (notice, minimum period for bids, requirement to take high bid) If you don’t you might encourage economic waste and it would probably be unconstitutional. Banks may be creatures of the state, but their security interest in the property is protected by the due process clause_ to the extent there is equity. _ You just need a reasonable process to determine the equity in the house.
How is the second component different from the proposal to authorize cram-downs of real estate in bankruptcy? The advantage of bankruptcy is that there are already institutions and a process in place that would be fairly legally secure. The disadvantages appear to be two: (1) It would require the debtor to expose other assets to disbursement; and (2) the lenders will tighten financing to adjust to this new long-term risk.
sam, I may not be understanding your proposal. Let’s assume that I’m in the top fifth quintile of income earners; I have a mortgage and other debts, but they are manageable on my income. Are you suggesting my income tax rates should be reduced if I use the benefit to pay down my mortgage? That appears to be a transfer of income to the better off with possible trickle down benefits to the less-well-off, if I end up spending more.
No doubt about it. However, I think the key to my suggestion is that there isn’t a property interest in non-existent equity if you understand what I mean.
My strategy avoids bankruptcy which I think is an advantage. It seems to be the case that lots of solvent people also have a lot of debt and disincentives to get out of debt.
Perhaps I missed your post in which you laid out your arguments as to why banks are “creatures of the state” and thus subject to the redistribution of their shareholders’ assets at the whim of the state. If I did indeed miss is please direct me to the relevant post and if not would you kindly complete the circle.
Thanks.
I assume you are using the sale as a means to achieving a market valuation of the house rather than have an arbitrary cramdown. I would have the interest cap done gradually. The only downside I see, is that this could drive doown the price of housing quite a bit, putting more houses underwater.
Steve
That’s certainly one reason. What I’m trying to accomplish by it is to avoid the moral hazard that pure cramdown would foster. You’re quite right that measures intended to reduce household debt are likely to drive down housing prices. The two are linked. If your objective is to drive down household debt, you’ve got to accept a fall in housing prices. If your objective is propping up housing prices, you’ve got to accept a higher level of household debt.
“Banks may be creatures of the state, but their security interest in the property is protected by the due process clause_ to the extent there is equity. _ You just need a reasonable process to determine the equity in the house.”
I don’t know squat about the due process clause, but I know credit underwriting like the back of my hand. A bank (on a home mortgage, or a collateralized business loan) relies on the sanctity of a first protected lien on the collateral. It prices and sets terms accordingly, and with regard to their independant view of total enterprise (equity) value. That’s their loan to value determinantion and risk….as it should be. Moreover, it sets those prices and conditions at the most beneficial to the borrower based upon that reliance on the first perfected lien and loan to value determination. I don’t know where you guys are going here; but it seems a bit confused. Rest assured you increase financing costs/risk/loan loss ratios and you will price up loan money.
Where are you guys headed?
One immediate problem comes to mind with your proposal to limit the mortgage insurance deduction. If you reduce the deduction, you will reduce home values. When people buy a house, they make decisions about how much to pay based upon the amount of the payment they can afford to make. If you limit the deduction, the same payment becomes more expensive. For example, if I have a $1000 monthly payment and a 20% tax rate, my $1,000 payment only costs me $800. If that deduction suddenly goes away, my monthly expenses increase by $200 immediately. The result of this is that you decrease what people can pay to purchase the underlying asset. Since home values ultimately are set based on what people are willing to pay, when you make the cost of financing more expensive by reducing the deduction, you lower what people are able to pay in the first place.
The problem now is not th absolute amount of debt, but rather the amount of debt relative to the value of the assets. If you reduce the amount of debt while simultaneously reducing the value of the assets, you have not really made progress on reducing indebtedness.
@PD
“Let’s assume that I’m in the top fifth quintile of income earners; I have a mortgage and other debts, but they are manageable on my income.”
I thought the premise was that most (mostest) of the household debt is held by folks at the top and that it is not manageable (in the sense of being paid down). I tried to fashion a carrot/stick approach.
My supposition was that the debt was manageable in the sense of making payments but presumably large enough that it inhibited further spending. To be honest I’m having some difficulty in making the facts, e.g. most of the debt is held by those in the top quintile, with the hypothesis of a balance sheet recession.
I’m beginning to think that a better explanation is an intolerance of risk. It’s too risky to spend, it’s too risky to save, it’s too risky to hire, it’s too risky to invest. Note that I’m claiming perception here, not actuality. I don’t know whether it’s actually too risky but I do have a very strong impression that over the last couple of decades the expectation of high returns at low risk has become quite noticeable.
BTW, the point that Drew raises above is that any strategy that addresses the problem of excessive household debt effectively may have very serious implications. That would mean that the cure may be worse than the disease and there really is no solution to the problem.
sam, I was trying to understand the proposal. Dave wants to talk in technical terms about incentives. I think there is significant political problem here if the government has a program that aims to help the wealthy keep their McMansions. Dave is proposing to help people get out from their mortgages, but they don’t get to keep the house as part of the bargain.
Drew, we’re just saying that the lender’s interest in the property is only as great as the value of the security. To the extent the lender is secured by value, the Constitution prohibits the government from taking any of that value without just compensation.
To give an example, if a lender loaned $100,00 for property that would now only sell for $75,000, then under Dave’s plan, the lender would have to accept $75,000 if the owner sold. The Constitutional question is whether the lender has received the value of the collateral and whether the process for determining the value of the collateral reflects fair market value.
That may not comport with the lender’s underwriting expectations and maybe the lender will adjust going forward, but it doesn’t look to me like residential lenders rated for the risk of mass housing depreciation to begin with.