Some economists think the credit crisis needs to be fixed at its source—in America’s housing market
GOVERNMENTS across the rich world have taken drastic steps to save the banking system. As the fears of outright collapse recede, their focus has turned to improving the supply of credit to households and firms by pushing market interest rates down and encouraging banks to lend more freely. But a growing number of economists, and now the Bush administration, believe that the credit crunch also has to be addressed at its source—in America’s housing market, where prices have fallen almost one-fifth from their peak, and foreclosures have soared (see chart).
Two features of housing finance make the crisis hard to resolve. The first is “no-recourse” home loans, which are standard in America (though not elsewhere). If a borrower defaults, a bank can claim back the property used as collateral, but nothing more. When the value of a home drops below the size of the mortgage, a borrower has a reason to default to escape his negative equity.
Borrowers’ freedom to disown their bad housing investments means the housing slump feeds on itself. A lender may recover as little as half the value of the mortgage from a foreclosure, after legal and other costs, because abandoned homes quickly fall into disrepair and can only be sold at a discount. And foreclosures intensify house-price falls by adding to the stock of unsold houses. An enlightened bank may be better off forgiving a part of a mortgage if that persuades borrowers to remain in their homes. But that route is often closed off because of a second feature of the housing market: securitised mortgages. When a troubled home loan is in a pool with other mortgages, held by a group of investors, there is no easy way to agree on a deal to forgive debt.
In response to this problem, Luigi Zingales, of the University of Chicago, thinks the government should temporarily impose a standardised way to rejig the terms of securitised mortgages. He proposes that a 20% fall in a neighbourhood’s house prices from the time when the borrower bought his house would automatically trigger an option to alter the terms of a loan. Lenders would be forced to write off a chunk of the original loan, shrinking the mortgage in proportion to the fall in house prices. In return they would receive a share of future house-price gains.
There are alternatives. Martin Feldstein, who chaired Ronald Reagan’s Council of Economic Advisers (CEA) in the early 1980s, suggests creating “mortgage-replacement” loans to prevent distressed homeowners walking away from their debts. Under the plan, the government would provide low-cost loans to all mortgage holders, worth 20% of their outstanding mortgage debt.
The bait for homeowners would be lower interest costs. Mr Feldstein thinks the scheme’s loans would need to have a fixed interest rate of around 2% to make a material dent in debt-service costs. In return borrowers would take on a slice of debt that they cannot welsh on: the replacement loan would not be secured on the home, but the government would have first claim on the borrower’s future earnings in the event of a default.
Lenders would benefit because the replacement loan would create a much larger cushion against default on the original mortgage. And the government would get something back for its money, since the loan subsidy would help stem the tide of defaults, prevent further fire-sales of empty houses and make mortgage-backed assets less risky for banks to hold.
If banks won’t lend, Fannie may
Another former CEA chairman, Glenn Hubbard, along with his Columbia University colleague, Chris Mayer, take a more radical approach. House prices could collapse, they reckon, because the downward pressure from foreclosures is made far worse by the scarcity and expense of home loans. To address this, the government should use Fannie Mae and Freddie Mac, the nationalised mortgage giants, to provide home loans to new and existing borrowers on terms that would be available if markets were working normally. They reckon the cost of a 30-year fixed-rate Fannie or Freddie mortgage is normally around 1.6 percentage points above the yield on ten-year government bonds, currently 3.7%. So the government could offer a benchmark 5.25% mortgage deal—matching the lowest rate in the past 30 years.
The Hubbard-Mayer scheme would be costly, since Fannie and Freddie could not lend to householders with negative equity—otherwise their new mortgages would be too small to pay off the old ones. Writing off negative equity could cost as much as $600 billion. Their benchmark for a “normal” credit spread is probably too low, since it is partly based on a period when risk was underpriced. Banks would also suffer from seeing profitable customers lured away by the offer of cheaper state-backed home loans. It would direct a lot of fiscal firepower at indebted homeowners, but would benefit other taxpayers only indirectly—a shortcoming it shares with Mr Feldstein’s scheme.
Allied to that objection is a bigger one: attempting to put a floor under house prices (or any asset prices) is hugely distortionary. For his part, Mr Feldstein emphasises that his aim is not to prop up inflated home values artificially. “I don’t want to stop a needed adjustment in house prices, but I don’t want that adjustment to overshoot because of foreclosures.” He believes the credit crisis will not be resolved until the incentive for borrowers to default—a uniquely American problem—is addressed. The proportion of underwater home-loans would double to around 40%, he reckons, if house prices fall by a further 15%—a drop that is widely forecast. If a fresh wave of borrowers hand back their house keys to lenders, it would leave many more mortgage-backed securities impaired than could be absorbed by the government’s Troubled Asset Relief Programme (TARP).
Given the extent of negative equity and the risk of a negative spiral of defaults and falling prices, efforts to keep homeowners in their homes may yet be necessary to solve the crisis. Mr Zingales’s proposal looks neatest. It would cost less, leaving resources free for a more general fiscal stimulus. But it won’t be entirely costless: any forced renegotiation, even a relatively cheap one, may well lead to a higher cost of credit in the future.
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