Efficient Credit Policies in a Housing Debt Crisis

By Eberly, Janice; Krishnamurthy, Arvind | Brookings Papers on Economic Activity, Fall 2014 | Go to article overview

Efficient Credit Policies in a Housing Debt Crisis


Eberly, Janice, Krishnamurthy, Arvind, Brookings Papers on Economic Activity


ABSTRACT Consumption, income, and home prices fell simultaneously during the financial crisis, compounding recessionary conditions with liquidity constraints and mortgage distress. We develop a framework to guide government policy in response to crises in cases when government may intervene to support distressed mortgages. Our results emphasize three aspects of efficient mortgage modifications. First, when households are constrained in their borrowing, government resources should support household liquidity up-front. This implies modifying loans to reduce payments during the crisis rather than reducing payments over the life of the mortgage contract, such as via debt reduction. Second, while governments will not find it efficient to directly write down the debt of borrowers, in many cases it will be in the best interest of lenders to do so, because reducing debt is an effective way to reduce strategic default. Moreover, the lenders who bear the credit default risk have a direct incentive to partially write down debt and avoid a full loan loss due to default. Finally, a well-designed mortgage contract should take these considerations into account, reducing payments during recessions and reducing debt when home prices fall. We propose an automatic stabilizer mortgage contract which does both by converting mortgages into lower-rate adjustable-rate mortgages when interest rates fall during a downturn--reducing payments and lowering the present value of borrowers' debt.

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During the financial crisis and in its aftermath, those segments of the economy most exposed to the accumulation of mortgage debt have tended to fare the worst. Whether one measures the impact by industry (construction), by geography (sand states), or by household (the most indebted), the presence of greater mortgage debt has led to weaker economic outcomes (see, for example, Mian and Sufi 2009 and Dynan 2012). Moreover, research suggests that financial crises may be more severe or may be associated with slower recoveries when accompanied by a housing collapse (Reinhart and Rogoff 2009; Howard, Martin, and Wilson 2011; and International Monetary Fund 2012).

These observations lead to an apparently natural macroeconomic policy prescription: restoring stronger economic growth requires reducing accumulated mortgage debt. In this paper, we consider this proposal in an environment where debt is indeed potentially damaging to the macroeconomy and where the government and private sector have a range of possible policy interventions. We show that while debt reduction can support economic recovery, other interventions can be more efficient. We also show that whether debt reduction is financed by the government or by lenders matters for both its efficacy and its desirability. Hence, while the intuitive appeal of debt reduction is clear, its policy efficiency is not always clear, and the argument is more nuanced than the simple intuition.

Our results emphasize three aspects of efficient mortgage modifications. First, when households are borrowing-constrained, government support should provide liquidity up-front. This implies loan modifications that reduce payments during the crisis, rather than using government resources for debt reduction that reduces payments over the life of the mortgage contract. The reasoning behind this result is simple and robust. Consider choosing among a class of government support programs, all of which transfer resources to a borrower, but which may vary in the timing of transfers. Suppose the objective of the program is to increase the current consumption of the borrower. For a permanent-income household, only the present discounted value of the government transfers matters for current consumption. But for a liquidity-constrained household, for any given present discounted value of transfers, programs that front-load transfers increase consumption by strictly more. Thus, up-front payment reduction is a more efficient use of government resources than debt reduction. …

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