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Policy Planning for the Next Financial Crisis

Dramatic growth in household debt preceded both the Great Depression and the Great Recession. Both episodes also were characterized by large, persistent declines in consumption. During the crises, highly leveraged households aggressively sought to reduce their debt burdens by postponing consumption. This was especially true of those that experienced large house price declines.

Highly leveraged household balance sheets are essential drivers of deep and prolonged economic slumps as households focus on lowering debt instead of buying goods and services that stimulate economic growth. In addition, indebted households were often unable to refinance their mortgage rates into historically low interest rates as home equity credit availability declined considerably after the crisis. This deleveraging of households has served as a drag in the rate of growth during a recovery and expansion phase.

So what should be the correct policy if another housing market crisis occurs? Should the highest priority be helping cash-short homeowners maintain spending in a weak economy and helping them avoid foreclosure by temporarily reducing or deferring mortgage payments?

Getting homeowners back to participating in the economy has focused primarily on two possible policy solutions: principal write-down and temporarily reducing monthly payments by deferring mortgage payments, reducing interest rates or extending the mortgages’ term. A principal write-down is when a policy is implemented to lower the borrowers’ loan principal during a housing crisis.

For example, you may owe $250,000 on your home, but your principal is reduced to $225,000. This not only affects how much you have in your pocket to spend today, but also offers stimulus for the entire remaining period of the debt. Overall, reducing the total amount owed could help reduce the number of underwater homeowners and strategic defaults, but it does not help the liquidity issues of cash-short homeowners trying to maintain their consumption patterns. It also may offer an incentive for moral hazard by highly leveraged homeowners who might expect to be bailed out in the future.

The second option for putting money in homeowners’ pockets today is reducing interest rates for short periods or maybe extending the duration of the loan so monthly payments are lower and homeowners meet their payments and have enough left to continue to spend and support the economy. One way of planning for this in the future is to redesign mortgages to allow contracts for lower monthly payments when both borrowing constraints exist and home prices fall. Lenders could play an important role in this process because they benefit from reduced mortgage defaults. This type of mortgage could have a clause to automatically refinance into a lower-adjustable rate even if a homeowner is underwater, thus allowing the homeowners to reduce spending to meet their mortgage payments and preventing them from defaulting. This would be contrary to what was observed during the recent crisis, when many illiquid homeowners were locked into high-interest mortgages, were underwater and unable to access refinancing at a lower rate. While packaging this type of mortgage would not be simple, it still has possibilities.

For example, let’s say you have a $200,000 fixed-rate mortgage at 6 percent for 30 years, with 12 monthly payments. Over the course of the loan, you would make 360 (30 x 12) payments. The monthly fixed-rate mortgage rate would be .06/12 = 0.005. Thus, the monthly payments would be approximately 200,000 x [0.005 x (1+0.005)^360]/[((1+0.005)^360)-1]= $1,199.10. Refinancing the $200,000 mortgage from 6 percent to 4 percent reduces monthly payments from $1,199.10 to $954.83 or a 20.37 percent reduction. The identical reduction in monthly mortgage payments would be reduced if the principal amount of the mortgage loan was written down from $200,000 to $159,258, also 20.37 percent.

Of course the best solution to any crisis is preventing one. The focus should always be the prevention of future housing crises from occurring ever again. Unfortunately, financial crises have occurred throughout history and will occur in the future. It is prudent to know the best policies to implement during any crisis to return the economy back to its long-run growth trend.

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