Readings: Reforming the Debt Establishment
When the Great Recession brought enormous job loss, record foreclosures, and a startling global market decline, there was plenty of blame to go around. Pundits cited lax lending standards, corporate greed, and failed government regulation. But the underlying cause, according to a new book by Amir Sufi, Chicago Board of Trade Professor of Finance, is lenders' inflexible approach to household debt.
In House of Debt, Sufi and Princeton's Atif Mian argue that recessions are a product of financial systems that foster too much private debt. And they suggest a new approach that could make it easier for the government and the private sector to manage future downturns, perhaps even prevent crises like the 2008 recession.
When Sufi and Mian looked at economic slumps as far back as 1810, they discovered that nearly every severe downturn, including the Great Depression, was preceded by a sharp run-up in household debt. They observed that poor mortgage holders retained their entire net worth in their homes, so that once housing prices declined the homeowners were left with no assets. With their net worth in ashes, they stopped spending, bringing the entire economy to a standstill.
The authors use the historical data to devise what they call a "levered-losses framework," which demonstrates that high levels of household debt not only amplify a crash, but also fuel the bubble that makes the crash inevitable by enabling people to buy houses at inflated prices. The researchers' framework also demonstrates that using taxpayer money to bail out banks while ignoring the problem of household debt doesn't work. Banks, after all, suffer because of the collapse in household spending, so putting money directly into the banks doesn't solve the problem.
A better approach, they suggest, is to address the problem of household debt straight on, by resolving the lack of flexibility in the way a loan is structured. When a home purchased with borrowed money goes down in value, the borrower still needs to pay off the entire original amount of the loan. The researchers' solution differs from conventional mortgages in that lender and borrower share the burden of responsibility: the lender offers downside protections during a bad market, while the borrower offers an upside capital gain during a strong market.
This means that if the value of a house goes down after a mortgage is taken out, the lender is required to lower the payments on the mortgage commensurately. On the other hand, if the house gains value during the course of the mortgage, the borrower must pay the lender a 5 percent capital gain. If the value of the house remains the same, both parties honor the payment terms of the original loan agreement.
Home-equity and mortgage loans aren't the only debt category that could benefit from a new, more flexible approach. Mian and Sufi also take a look at student loans. When many freshmen entered college in 2006, they had no idea that when they graduated four years later it would be nearly impossible to find a job. They borrowed for tuition on the assumption they would earn sufficient income to repay the loan, but they were wrong. Does this mean that they also should be crushed under repayment schedules they cannot meet?
Mian and Sufi don't think so. Student loans, they propose, should be made contingent on measures of the job market at the time the student graduates. Recent graduates should be protected if they face a dismal job market upon completing their degrees. At the same time, they should be obligated to pay the lender more if they are successful in landing a good-paying job.
Perhaps lender flexibility on debt can help us avoid the boom-and-bust cycles that lead to severe downturns. Borrowers in bad situations require more options, not less, the authors conclude.–Robin Mordfin