Delevering

Matt Rognile takes aim at people claiming “deleveraging” is an important reason behind the prolonged downturn:

In failing to understand this core logic, most commentary about “deleveraging” is rather bizarre. At some level, it’s the same cluelessness that we once saw from central planners: they’d trip over themselves in the complexity of fixing a shortage in one market or a glut in another, never quite realizing that the price mechanism would do their work for them. Right now, historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed. Yet we see pundits lost in all kinds of complicated, small-bore proposals to stimulate the economy—when the fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.

Elsewhere, he argues that many households, despite the fall in home prices, do have substantial assets. 

The deleverage hypothesis argues that aggregate GDP will remain weak as long as household consumption is held back through the presence of debts. Rognile retorts that the balance of savings and investment is adjusted through interest rates; and that the changes in net assets can’t really support economically meaningful drops in consumption corresponding to the output declines we’ve seen. 

I think there’s a lot true here. David Beckworth has also made  a number of powerful arguments connecting deleverage to monetary policy:

For every household debtor deleveraging there is a creditor getting more payments.  Yes, household debtors have cut back on spending, but so have creditors.  The creditors could in principle provide an increase in spending to offset the decrease in  debtors' spending.  They aren't and thus the economic recovery is stalled. In other words, the problem is as much or more about the build up of liquid assets by creditors as it is the deleveraging of debtors… 

The key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them.  This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too.

I think Beckworth actually makes a more powerful case than Rognile. Even if households had good reason to save more; it’s not obvious that lower household consumption would necessarily lead to lower aggregate output, so long as the banks and creditors receiving those payments went out and lent the money. Then the usual money multiplier arguments would ensure a rapid circulation of credit throughout the economy, raising output. After all, we typically think that higher saving and investment is a good thing for economies; as opposed to thinking that money saved is wasted. 

There are two reasons that isn’t going on, relating to an excess demand for money: households desperately want to hold more liquid assets and hold fewer debt commitments; while creditors also are inclined to hold liquid assets rather than lend those out. Logically, the only way that a flow of money from households to creditors can have any aggregate effects is if agents in an economy simultaneously have an excess demand for money not met by the central bank. 

When you think about it this way, it becomes easier to diagram how to think about deleveraging. There are basically three categories I see:

1) People who think that deleveraging is real, and no amount of monetary stimulus will help. 

These are people like Richard Koo. Their argument goes that the presence of excess debt is the key constraint holding back economic growth. No amount of monetary stimulus will fundamentally change the asset position of households, and so there’s no way it will alter consumption or output (or, at least, not to the degree that is necessary). Raghuram Rajan may believe something like this, as best as I can tell. The MMT folks are probably best placed here as well. 

As Beckworth and Rognile point out above, this view doesn’t make sense given the conventional understanding of how monetary policy ought to operate. If we desire greater spending from households or creditors; we can always make that happen by flooding the system with money. 

2) People who think that deleveraging is real, monetary stimulus could help, but the Fed won’t deliver enough. 

These are people like Paul Krugman. As Rognile points out — Krugman is careful to note how deleverage is only an issue if you’re in a liquidity trap, but that nuance tends to be lost among many other commentators. Elsewhere, he has argued that fiscal stimulus is only worthwhile as long as interest rates are zero — at other times, he often takes for granted that monetary policy ought to handle the brunt of aggregate demand management (or at least he did in the '90s). 

In that sense, Krugman actually agrees with Scott Sumner on more issues of intellectual substance than, say, with Keynes. It’s just that Krugman believes that in this particular instance, we happen to be in some kind of liquidity trap in which monetary policy won’t be sufficient to tackle the headwinds of a deleverage cycle. 

3) Then; there are people who believe that deleveraging may be a concern; but monetary policy (even with a zero-rate bound) ought to handle everything.

Here are the market monetarists like Scott Sumner and David Beckworth, as well as Matt Rognile. The belief is not only that monetary policy can fix any conceivable deleverage shock; but that the Fed could do so tomorrow given the set of tools they have; involving perhaps the adoption of a price level, getting more QE, imposing interest on reserves, or offering guidance on the future path of interest rates. 

Many people on sides 1 and 2 agree on issues; but there’s a fundamental conceptual difference there. Suppose, as Mike Konczal likes to imagine, that we wake up tomorrow and find that interest rates are actually 2%, rather than at 0% for the short-term Treasury rate. What should we do? Some people (like perhaps Koo?) would argue that changing that rate wouldn’t do very much. But people like Krugman would argue that, if we were in an environment in which conventional monetary policy could operate, then that’s basically the only policy channel we should use to get output back.

The only difference between sides 2 and 3 is whether or not the liquidity trap proves binding. This seems like a fairly trivial issue; but it determines entirely whether or not you think that we should adopt fiscal stimulus, or simply Ben Bernanke with a more aggressive Fed Chair. 

Where’s the Evidence for Deleveraging?

Some of the best evidence in favor of a deleverage model comes from cross-sectional cuts comparing debt to economic outcomes. For instance, Mian and Sufi find that high household debt areas have lower employment than low household debt areas:

One way to think about this is in some kind of Bernanke-Gertler approach in which households use their homes as collateral. When home prices were increasing, households used their houses like credit cards and extracted some of the equity. Now, when debt levels are high, the same households are cutting back; and employment is suffering. (Philippon and Midrigan have a paper highlighting this channel, though they also emphasize the role of monetary policy to counteract that)

The issue with this type of finding is ensuring identification. It seems intuitive that the parts of the country which participated in the housing boom most heavily would have some of the worst outcomes right now. But what’s the channel by which that operates? If it’s the debt, than we have some possible fixes — do some mass refinancing or mass principal writedowns (which may be good ideas themselves for other reasons).

But I don’t think it’s obvious that demand-side issues are at work in explaining the poor economic outcomes of post-real estate bust areas. Erik Hurst instead points to supply-side effects coming from the structural challenges in re-orienting a local economy away from real estate investment. He points to the following graph:

Here, he shows that the change in unemployment rate mirrors closely the change in the composition of output away from real estate-financial sectors. You have laid off construction workers, for instance, who find it difficult to retrain and find new jobs. Lowering outstanding mortgage principal won’t necessarily help retrain a laid-off-construction worker as a nurse. In fact, lowering the principal on a mortgage might induce that laid-off-worker to remain in a housing bust area instead of moving to North Dakota, where the unemployment rate might as well be zero; raising unemployment (this is basically what Lee Ohanian and Kyle Herkenhoff argue). The economy may just be in for a sustained period of slowdown as individual agents attempt to find a new sustainable equilibrium. 

I’m not wed to either the demand/debt or construction/supply approach — I just want to point out it’s not obvious to think about the role of debt, or even the relative ratio of supply side and demand side issues in explaining a weak economy. No one has credible causal estimates of how lowering debt burdens would help household or economy-wide welfare. Household and bank-centered approaches are very appealing in trying to explain why the recovery has been as weak as it is, but I don’t think all of the stories hang together. 

The Texas Non-Bubble

Mike Konczal serves up some interesting graphs on the Texas economy. One important element he flags relates to jobs and the debt burden. Texas managed to go through the past decade with no housing bubble, and a limited increase in housing-related debt. This served the state a great deal in avoiding foreclosure and a subsequent “balance sheet” recession driven by households aiming for deleverage. Mike offers this commentary on how Texas did that:

Fisher states that a free regulatory environment is causing this growth, but the rather strong regulations on the mortgage market and growth in the housing stock are more likely the factors in preventing the build-up of housing debt that in turn isn’t holding back the economy. There are strong regulations on the housing market, especially in terms of housing equity loans that in turn make it harder to bid up values.

Well, why did Texas avoid a bubble? Mike flags consumer regulation. But I’d also point to lax local zoning and land use regulations.

The chief restriction on home equity loans in Texas is that they cannot exceed 80% of the market value of the home — essentially requiring all borrowers to have some sort of equity. Cash out refinances were restricted in the same manner. Requiring that homeowners place a sufficient amount as a downpayment, and restricting people from using equity gains as collateral to acquire new debt, substantially reduced speculation and cash outs.

But it’s something of an open question as to how much this reduced price fluctuation. Certainly, requiring sizable downpayments lowered the plausible group of buyers in a given property. However, the restriction on refinancing was probably a factor reducing leverage more than increasing price. Ie, it prevented existing homeowners from doubling down on home prices by acquiring more debt. Certainly, the option to extract future equity may have enticed buyers in other states. But limiting future equity extraction may or may not have been a small factor in actually inducing higher prices.

By contrast, there are good theoretical reasons to focus on housing restrictions. Paul Krugman argued all the way back in 2005 that house price appreciation seemed to be much higher in areas where geographic and zoning restrictions lowered the available supply of housing. Since then, Ed Glaeser and co-authors have written a paper arguing that price increases in housing were driven most strongly in areas where housing supply was relatively fixed.

This makes a lot of sense from a demand-supply framework. Where supply is flexible; builders respond to greater demand for housing by building more houses, so prices remain flat. Where supply is inflexible, increases in housing demand largely translate into increases in prices, not increases in the number of houses built. Even if the increase in housing demand comes from speculators who place little money down and expect to extract future equity from their houses; as long as builders can keep building this increase in demand will not translate into an increase in prices. You need both an increase in demand, as well as inflexible supply to generate an increase in housing prices.

The national data backs this idea up well enough, but there are two big stumbling blocks: basically Las Vegas and Phoenix. The housing market in these areas saw huge price increases, but the thinking is that land policy should have been fairly flexible here. If you look at both markets specifically though, the real problem may also have been inflexible housing supply:

In Nevada, something like 85% of all land is federally owned, including a lot of the land in the neighborhood of Las Vegas, and overseen by the Bureau of Land Management. A local journalist at the Nevada News & Views, Mike Chamberlain, has repeatedly emphasized the role of government ownership of land in building up the bubble. A federal law in 1998 split land sale proceeds with local governments, which gave local authorities strong incentives to try to bid up land sales. As this Economist article mentioned, other local housing participants in 2005 thought the government was far too stingy in releasing land at a suitable pace. At the very least, there are good reasons to think that not all of the land outside Las Vegas was free for development.

Phoenix is also wrongly classified as freely developable state. Rather, beginning in 1998, the state opted for a “growth management” policy limiting land use. Similar to Las Vegas, land outside of Phoenix land was held by the government, which limited sales to maximize revenues. This link from Demographia (honestly not sure how I ran across this, so perhaps take with a grain of salt) argues in Maricopa county, home to Phoenix, agricultural land was selling for a fraction of development land. The problem wasn’t a land shortage per se, so much as a segmented real estate market in which agricultural land was not easily convertible into housing. Wendell Cox at New Geography argues:

Building is largely impossible on the "abundance of land" surrounding Las Vegas and Phoenix. Las Vegas and Phoenix have virtual urban growth boundaries, formed by encircling federal and state lands. These are fairly tight boundaries, especially in view of the huge growth these areas have experienced. There are programs to auction off some of this land to developers and the price escalation during the bubble in the two metropolitan areas shows how a scarcity of land from government ownership produces the same higher prices as an urban growth boundary...

In Las Vegas, house prices escalated approximately 85% relative to incomes between 2002 and 2006. Coincidentally, over the same period, federal government land auctions prices for urban fringe land rose from a modest $50,000 per acre in 2001-2, to $229,000 in 2003-4 and $284,000 at the peak of the housing bubble (2005-6). Similarly, Phoenix house prices rose nearly as much as Las Vegas, while the rate of increase per acre in Phoenix land auctions rose nearly as much as in Las Vegas.

Somewhat conspiatorially, a similar situation prevailed in Spain. An Economist article has noted that building on vacant land required local governments to extend town limits, and entitled them to 10% of development land (which town governments then sold for revenue). I find it suspicious that three of the biggest housing bubble markets in the world in the last decade were characterized by these sorts of crony capitalist land ownership rules. It’s easy to imagine how governments could limit the sales in these auctions to artificially constrain supply and encourage price inflation.

I think all of this is at least circumstantial evidence to think that local zoning and housing policy may have played a role in preventing a housing bubble in Texas. There are other factors at play too — Texas has high property taxes, further limiting speculation, and it tends to draw its migrants from states in the Midwest, which also saw low property price appreciation. By contrast, Nevada and Arizona saw a lot of migrants from California (cashing in on previous house appreciation), while Florida had a lot of migrants from pricey New York.

Still, there’s no reason we can’t follow both the consumer regulation and the lax zoning. Texas’ housing policy involves “regulations,” but ought be relatively palatable for regulation-distrusting libertarians and others to swallow. There aren’t strict mandates on what or where to build, but simply sensible rules requiring that homeowners keep sufficient collateral in their homes. This seems reasonable enough. Not to get too into the politics of this, but the chief opposition to collateral requirements tends to come from progressive community activists worried that downpayments punish wealth-poor families.

Meanwhile, the loose regulations on housing seem to do a great deal of good in preventing price bubbles from building up as well. Those, too, seem reasonable. There’s no reason not to adopt both sets of policies throughout the nation. That would lower rents, limit speculation, and likely lower house price volatility. It’s too bad Rick Perry isn’t running on that platform.

Bubbles and Unemployment

There’s a lot of commentary going around on why unemployment has proved to be persistently high during the recovery. As Yglesias notes, this boils down to the question “Are recessions caused by asset price busts fundamentally different from recessions caused by central bank efforts to curb inflation?” Paul Krugman has a strong take on this:

Brad DeLong has recently written up a clearer version of a story I’ve been telling for a while (actually since before the 2008 crisis) — namely, that there’s a big difference between inflation-fighting recessions, in which the Fed squeezes to bring inflation down, then relaxes — and recessions brought on by overstretch in debt and investment. The former tend to be V-shaped, with a rapid recovery once the Fed relents; the latter tend to be slow, because it’s much harder to push private spending higher than to stop holding it down.

The idea that the precise conditions of this recession are different has implications for the favored policies of both the right and left. On the left, some folks believe that the notion of balance sheet recessions calls for more measures to tackle household negative equity, optimism for fiscal policy, and skepticism regarding monetary policy (say, Krugman). On the right, other people emphasize mismatch problems in the labor market and the role of structural forces behind unemployment. They are frequently skeptical of how fiscal policy can fix these problems (sometimes, also monetary policy). In general, there are widespread beliefs that some particular features of the crash have limited the scope for traditional macroeconomic stabilization policies.

Via Stephen Williamson, Minneapolis Fed President Narayana Kocherlakota has a new paper that goes into this issue. He draws on the Keynesian work of Roger Farmer, who shows this graph:



Farmer’s idea is that the rate of unemployment at any time is indeterminate due to problems in the labor search market. In the absence of markets for the search time of workers, price signals are not necessarily sent to match workers with the right jobs. Instead, the level of unemployment is determined by expectations of the strength of economic activity, which is proxied by stock market performance. One problem for this idea lies in explaining why unemployment has been slow to recover even as the stock market has recovered. Farmer writes,

This paradigm provides us with a new way to think about large recessions like the Great Depression and the Great Recession of 2007—2009. Using the model from this paper I would argue that the world economy in 2008 was headed rapidly towards a high unemployment, low wealth, equilibrium. The move to this bad equilibrium was triggered by a loss of confidence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets led to an amplification of the crisis as panic hit the global financial markets.

In the winter of 2011, the US labor market had still not recovered. I believe that much of the problem is connected with a lack of confidence bylobal investors who are concerned with the possibility of a further collapse. Even though the US stock market may be appropriately valued based on historical price earnings ratios — market participants are concerned that the value of stocks could fall further. Variations in the level of confidence are manifested in changing risk premia that are fully rational given the unpredictable behavior of future traders in the asset markets.

I find this argument more persuasive in explaining the employment dowturn than the failure of employment to recover; but it is easy to imagine alternate models in which employment growth is asymmetric with respect to the business cycle.

Kocherlakota's innovation is to bring this unemployment picture into a broader model involving bubbles and monetary policy. While his model is fairly complex, the end result is simple — as with Farmer’s model, the level of unemployment is ultimately determined not by prevailing wages, but rather by the amount of aggregate demand. The collapse of an asset bubble results in a substantial drop in demand, and will result in a hike in unemployment unless the central bank proves sufficiently accommodative in lowering nominal interest rates.

One way to think about this is to compare the stock market bust in 2000 with the housing bust in 2008. In both cases, you have an asset that drops dramatically in value (tech companies, housing) that results in large drops in comparable financial securities (tech stocks, mortgage-backed securities). The total wealth loss in the economy was roughly comparable between the two cases. Yet for the 2000 crash, the Fed was able to lean against the drop by moving conventional monetary policy enough. In the second case, the Fed quickly hit the short-term nominal interest rate barrier of 0, and was unable to ease further though conventional channels. It did pursue unconventional policies like QE2, but was hesitant to do so and faced unprecedented levels of backlash for the easing that they did happen.

So, one way to read Kocherlakota is the following: given that monetary policy-induced demand fixes the rate of unemployment, recovery difficulties now reduce to the fact that the Fed has been insufficiently accommodating as the some interest rates hit the zero-rate bound. If the Fed instead proved more willing to consider unorthodox policies like quantitative easing or currency depreciation, we could have whatever degree of unemployment we liked.

The ultimate origin of a recession, in this model, is completely irrelevant to the possibility for the recovery. Issues with debt overhangs, structural unemployment, etc. are all second order effects relative to the fact that Fed-induced nominal spending has lagged; and the optimal recipe is not fiscal stimulus, but further Fed-based easing. Recessions caused by asset-bubble bursts do not differ from the garden variety recession, as long as the Fed is in fact appropriately accommodating.

So, the real issue is not that bubble-induced recessions are diffrerent in some way, but rather that policymakers respond to them differently. Rather than saying “the recovery in the 80s was quick because it was a Fed induced recession”; the issue instead is that the Fed had more scope to tackle that recession than this one.

Supply Side Mortgage Financing

On the recommendation of Mike Konczal, I checked out Adam Levitin’s account of the housing (with Susan Wachter). It’s a pretty long paper with a single core idea: to figure out what happened with the financial crisis, look at prices and quantities. Levitin observes that the yields (ie, interest rates above other interest-bearing assets) on mortgage-backed securities fell dramatically during the subprime boom, while the quantity of such products grew dramatically. The lesson to draw from that is that a rising supply of mortgage finance must be the chief culprit for the crisis, not demand. If the demand for mortgages was rising (say, from federal housing policy), the price of risk in mortgage markets would steadily rise. The fact that they instead fell points to the role of increasing supply in lowering the risk premia on mortgages. Levitin attributes this falling cost to mispriced mortgage securities.

Here’s a graph from a Fed paper by Diana Hancock and Wayne Passmore I'll get to in a bit that illustrates this pretty well:

If you compare the pre-boom era "Normal" with the subprime boom, it’s clear that mortgage yields fell dramatically relative to Treasury rates (ignore the crisis era stuff).

This is a clever idea, but attributing all of that fall in interest rates to mispricing seems a pretty bad assertion. There are many reasons why yields could fall. As I just blogged, large foreign inflows of capital could lead to a lower price of risk, though this scenario isn’t mentioned in the paper. Though Levitin dismisses monetary policy quickly, Rajan has argued that periods of absolutely low interest rates might generate a pattern of increased leverage and yield-seeking that would describe this data equally well.

But what I found most troubling was the use of simple market yields. It’s true that a fall in mortgage yields could imply a lower risk premium, all else equal. But when pricing a mortgage, a lot more goes in than just credit risk. Borrowers of mortgages typically have the ability to pay back the mortgage in full — for instance, by refinancing their mortgage to a lower rate. This is bad from the point of view of an investor, since borrowers are most eager to "prepay" their mortgage once interest rates are low. So, at exactly the point when interest rates fall (and you have fewer good investment options), mortgage borrowers give you all this cash. To deal with this, when you lend money in the mortgage market, you receive a prepayment premium for taking on that risk, and that goes into pricing a mortgage. The factors determining prepayment risk, as well as other risk determinants, changed dramatically during the subprime boom era, so it's not clear whether a falling risk premia explains everything.

Fortunately, the Fed paper from above does break this out. While this can get very complex, one simple check is to compare the MBS yield over Treasury (graphed above) to the option-adjusted spread (OAS) over Treasury (graphed below).

The OAS here is designed to pick up the portion of the mortgage yield attributable to the prepayment risk. You see that the OAS spread went down quite a bit during the subprime boom years as well. Overall, the MBS yield over Treasury (which Levitin interprets only as credit risk) fell by ~.7%. Yet ~.55% of that fall is attributable not to changes in risk preferences, but instead due to changes in the premia for carrying prepayment risk.

And the fault for that goes exactly to the Fed/global investors. The Federal Reserve promoted a climate of low interest rates, while global investors too pushed interest rates down. In response, carrying the prepayment risk of mortgages became lower (as borrowers didn’t have much room to refinance at substantially lower rates), and mortgages became more attractive as an asset class. The net change in mortgage yields due factors other than the prepayment risk should be something like 15 basis points; and some of that may also be attributable to other changes in the financing climate (the authors claim a sizable fall in the roll-over risk in this period associated with having to refinance debt holdings. This, too, can be attributed to interest rates that were persistently low). Though the authors of the Fed paper don’t seem to break this out — it’s very possible that the credit risk for mortgages actually went up during the subprime years.

Not only that, but the stock of borrowers grew quickly in response to these shifts in interest rates, suggesting that homeowners in this period were highly responsive to the price of mortgages. It’s possible that factors like land use regulations, a bubble mentality, lower downpayments, etc. may have been responsible for that, and that responsiveness is as important as the initial shock.

To be sure, the fact that the risk premium seems to have remained roughly constant even as worse borrowers took out mortgages may suggest that the risk premium may not have been high as it should have been. And I don’t understand this field nearly as well as I should, so please check out both papers and tell me where I’m getting things wrong. But I call this as another win for the camp blaming the Fed/foreign investors.

Edit: Adam Levitin has responded in the comments. He makes the good point that the Fed paper only looked at Agency MBS; while the pattern may well be different for private-label MBS, many of which were given out to loans on an adjustable-rate mortgage.

Konczal on Mortgages

I had hoped to write an angry post in response to Mike Konczal’s latest missives on mortgages; but his pieces are far too reasonable and well-done. Instead, I’ll agree with many of his points and make some hay over small differences.

The way I think about mortgage debt generally is through an Irving Fisher perspective. Prices for assets and goods are determined in competitive markets, and so can fluctuate over a business cycle. Contracts like debt, on the other hand, remain fixed in nominal terms. This causes huge problems in a real estate slump combined with recession, as you see more households struggling to make payments on now-unprofitable properties.

You can see that in this Federal Reserve report. Household net worth plunged in this recession, led by large drops in real estate assets. But household real estate liabilities—their debt burden—remained relatively constant.

That’s where the push for modifications, for Right to Rent, for cramdown, etc. comes from—an attempt to lower the principal balance on homes so that housing stays a reasonable bets for owners, rather than albatrosses holding down spending and consumption.

Modifications

I think the best way to make this happen would be if mortgage servicers got on the phone with delinquent borrowers and wrote down seriously underwater homes to a level that would induce people to keep making payments. Servicers should have a great deal of interest in cutting these deals; these types of haircuts happen all of the time for other types of debt; and they used to happen for mortgages as well.

But there are variety of reasons this isn’t happening now, or at least aren’t happening effectively. Banks are reluctant to expose real estate losses, because that would force them to realize accounting losses on their balance sheets. One suspects that many American banks are insolvent and are trying as hard as possible to avoid exposing that issue. Other problems include coordination problems with securitized loans. The act of chopping up a loan, combining it with others, and selling it as a security makes it much harder to monitor the original loan and come up with a deal if necessary. Then there is Fannie and Freddie’s inability to properly use HAMP, which makes no sense.

Banks really have no business harassing “strategic” borrowers given the cynical attitude they hold towards going bankrupt if necessary, and lapping up federal funds if possible. The real estate mess is their own fault for not negotiating win-win deals with customers who have problems, which is something they are perfectly willing to do for corporate clients.

Cramdown
For these reasons, I’m becoming more willing to look at Konczal’s preferred solution of a cramdown—allowing judges in bankruptcy courts to write down the principal on homes themselves if someone files for a Chapter 13 plan. I still find this a less appealing option than giving servicers the proper incentives to do it on their own, but we’ve seen how well that strategy has worked.

There are a couple of problems with this approach that Konzcal skips over, and a couple of ways to fix them. One big problem is that the vast majority of Chapter 13 plans fail, and we don’t have a good sense of why this is. Cramdown in bankruptcy would only apply for people who fully complete their bankruptcy plan, so this fix would just kick the problem down the road for most people. I suppose you could argue that the reason bankruptcy plans fail is because the home wasn’t written down enough; but it seems more likely that people become unemployed/lose income, and are using bankruptcy purely as a delaying tactic.

Then there are the problems that changing the bankruptcy code would have on the willingness of people to file for bankruptcy, and the willingness of banks to extend future credit. The more we make mortgages disposable, the more expensive it will be to get a mortgage. Of course, that will have the positive effect of reducing the number of risky borrowers. But it will also raise the pressure to get the government more heavily involved in mortgage lending, and force even safe borrowers to pony up more monthly income to rent payments. As Konzcal never tires of telling us, the steady rise of payments going to service secured debt eats away at disposable income.

A good way to fix these problems would be to make cramdown retroactive—only available, say, to mortgages purchased before 2008. We could even think about tying cramdown rules to zip code level price changes to reduce judicial discretion—though one suspects judges already apply fairly simple and consistent rules.

Costs of Default
But I want to push against two ideas—that the concern over strategic default is entirely unwarranted, and that subprime mortgages are a horrible deal. The problem is that mortgages come embedded with the “option” of default, since you can walk away at any time, usually without legal recourse (though, of course, your credit score will take a hit).

Homeowners in the past have exercised this option sparingly, as they want to stay in their homes, and because of social norms which argue against mortgage default. Indeed, banks relied heavily on these norms as they rolled out an unprecedented expansion in home mortgages and home equity lines of credit. These norms are shifting as delinquencies and foreclosures skyrocket. We have some evidence now that mortgage default gaining popularity relative to credit card default. For an individual borrower, looking at your home through a pure profit-loss perspective is the way to go. But when everyone starts doing this, that induces more and more people to walk away, which lowers prices, which makes even more people walk way. Ultimately, if mortgage debt was no more secure than credit card debt, it would be prohibitively expensive for all but a narrow minority of people. This may be an attractive world to move to, but the costs of getting there in the middle of a housing bust would be large.

Then, there’s the issue of how to think about subprime borrowers who took out these loans and are now suffering. Again—I think the right way to think about them is to realize that these borrowers bought a product with an embedded option. They had the ability to walk away if things ever went south for them—and, in many cases, they are now exercising that exit option.
I think this better fits a story of predatory borrowing, rather than predatory lending. Remember that it’s difficult to gauge the success of an investment from a purely ex post perspective. We only observe one particular economic outcome, but many other outcomes were possible when you made the investment. Had housing prices kept going up, subprime borrowers would have done very well indeed—and they did in fact do quite well for a number of boom years. Sure, they didn’t build equity—but they they pulled tons of cash out from their home to consume more than they could otherwise. That sounds like a pretty good deal to me. Allowing people to get a product with great upside and limited downside sounds like a far worse deal for the banks doing the lending than for the people buying the product.

This is also why I'm much more excited about FHA's threat to deny mortgage insurance to strategic defaulters. Ideally, I would like FHA to deny mortgage insurance to anyone who has gone delinquent on a mortgage in the past. I'm skeptical of the idea that the GSEs were the "cause" of the real estate meltdown, but they are clearly sinking ships, and any attempt to raise their underwriting standards would be welcome.

What Next
I want to go a little further than Konczal and argue that our failure to deal with debt generally is an issue. America’s debt-to-GDP is around 300%. These aren't the catastrophic levels of Iceland or even England, but is a serious issue. Replacing private debt with public debt doesn't entirely deal with this issue either. We need serious attempts--default, bankruptcy, or inflation--to erode the value of debt contracts; and then tax reform or regulations to limit the system-wide desire to take on additional debt. I used to be skeptical of this idea, but debt-fueled growth really is not sustainable, and destroys an economy's resilience.