The housing market is where the Great Recession started. It’s the main thing delaying recovery, and the reason fiscal and monetary stimulus (traditional and modern) haven’t worked better. The U.S. and U.K., especially, could have done a lot about it, but chose not to.
Barack Obama’s administration has finally decided to try harder. It wants to encourage targeted debt forgiveness, but it’s being blocked by the Federal Housing Finance Agency, the independent body that oversees Fannie Mae and Freddie Mac. Edward DeMarco, acting director of the agency, explained his objections in a letter to Congress on July 31. Treasury Secretary Timothy Geithner replied immediately, urging him to think again.
Let’s be clear about the context. The centrality of housing finance is the critical lesson of the past four years. Loans secured against housing drove prices to unsustainable highs. When valuations dropped, families saw their savings disappear. Millions moved from positive to negative net worth. This leveraged collapse in wealth hit consumption and output directly -- but that wasn’t the end.
Falling house prices and high debt combine to cause a multiplier effect, according to a study of 99 housing busts in 25 countries by the International Monetary Fund’s economists. In a housing bust with overborrowing, consumption falls four times more than you would expect from lower house prices alone.
Crippled banks add to the problem; the surprising thing is, they don’t account for all the difference. “The relationship between household debt and the contraction in consumption also holds for economies that did not experience a banking crisis around the time of the housing bust,” the IMF says. A debt- driven housing boom and bust is uniquely damaging even if banks aren’t dragged down, too.
There’s more. Excessive debt is choking the recovery. Borrowers are struggling to deleverage, and will be for years. This absorbs some of the demand that fiscal stimulus would otherwise have delivered.
What about monetary stimulus? Why haven’t lower interest rates worked more powerfully -- especially long-term interest rates, where quantitative easing has pushed them down, like in the U.S.? Again, look to the housing market. Mortgage rates have fallen, but because lenders have suddenly decided to be careful, struggling borrowers with fixed-rate mortgages can’t refinance.
You see the results. Borrowers can’t sell their houses to move and find work because they are underwater, owing more on their mortgages than their homes are worth. Others have fallen behind on payments and face foreclosure, which leaves borrowers, lenders and innocent bystanders all worse off. Millions of houses are already in foreclosure, blighting neighborhoods and delaying a housing recovery. A “shadow inventory” of houses still at risk of foreclosure overhangs the market.
Getting serious about debt forgiveness back in 2009 would have made a big difference. Even now, with signs that house prices are bottoming out in the U.S., it makes sense. The Federal Reserve has called for principal reduction for underwater borrowers. So has the IMF.
The point is, principal reduction can be win-win-win. The losses that foreclosure and the threat of foreclosure create are so great that the gains from avoiding it -- judiciously spread around -- can make everybody better off. A partially forgiven loan obviously makes the borrower better off. It can make the lender better off, too, if the good new loan is worth more than the about-to-go-bad one it replaces. Crucially, it can be in the public interest as well, if it reduces the economic externality of foreclosure blight and stops house prices undershooting.
With the Treasury promising to pay Fannie and Freddie’s extra administrative costs, plus a nice incentive on top, what’s DeMarco’s problem with targeted loan reductions? He has several, but the main one is the risk of “strategic default.” This danger shouldn’t be dismissed. The FHFA is right to weigh it. But, as the Treasury argues, its reasoning looks wrong.
The danger, according to DeMarco, is that underwater borrowers who can afford to keep making their payments will try to take advantage. “Will some percentage of borrowers who are current on their loans be encouraged to either claim a hardship or actually become delinquent to capture the benefits of principal forgiveness?” the FHFA asks. It thinks the risk is especially high for Fannie and Freddie, because the new forgiveness program would be publicly announced, government endorsed and implemented systemwide.
I’d be surprised if strategic defaults were a serious problem under the Treasury’s proposal. Actually, the danger might go the other way. There’s a trade-off here. You can reduce strategic defaults by targeting debt relief carefully, as the Treasury intends -- but the more careful you try to be, the more you’ll also rule out debt reductions that make good economic sense. In other words, you can be too careful. Complex eligibility requirements have hobbled the administration’s previous mortgage-relief initiatives.
If anything, Geithner’s proposal for targeted forgiveness risks making the same mistake. At any rate, the rules would mean that no borrower could be certain in advance of getting a reduction. Strategic default would therefore be risky. And the Treasury is offering to go further: “We have indicated to FHFA our willingness for [Fannie and Freddie] to include an asset test or other type of hardship screen to maximize the likelihood that only borrowers with genuine hardships receive principal reduction.” This is cautious to a fault.
The administration should have pressed this issue to the right conclusion years ago, but it’s not too late for targeted debt relief to help speed the recovery. Geithner’s right. DeMarco should think again.
(Clive Crook is a Bloomberg View columnist. The opinions expressed are his own.)
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