Here is a radical proposal from John Kemp, the former Sempra Metals economist, who seems to have had enough “resting” between jobs. His provocative ideas would appear to apply to the UK as well as the US.
Before you click “more” be aware that this is a 2,000 word read…
First take a deep breath, and recall President Franklin Roosevelt’s wise advice that there is nothing to fear but fear itself.
Then let’s admit something painful: The United States is bankrupt, in the sense that it’s assets (housing stock, corporations and cash flow, plant and machinery) are now worth much less than its liabilities (in the form of mortgage-backed securities, other debt and loan instruments). In particular, large parts of the housing stock are now worth much less than the owners paid for them, and less than the outstanding value of the mortgages, or the collateralised bonds that have been issued against them.
US house prices have already fallen around 20% from their peak according to the Case-Shiller index of repeat home sales in 20 metropolitan areas, and there is little doubt they will now fall further, perhaps another 10% or more, as the credit crisis works its way through the real economy, raising unemployment, depressing incomes, and making refinancing increasing difficult. Even after current and prospective price falls, US households still have considerable NET equity in their homes.
By the end of H1 2008, homeowners still held about $8.7 trillion worth of net equity after adjusting for mortgages, according to the Federal Reserve’s Flow of Funds Accounts (Table B100 line 50). Households real estate assets were valued at $19.429 trillion while they had borrowed $10.639 trillion against them. But net equity had already fallen -$1.135 trillion (-11.4%) from its peak in Q1 2007, when it stood at $9.924 trillion, and the equity cushion will continue to shrink as home prices fall while the debts secured against them remain unchanged.
The situation is far worse than this net equity figure implies. A significant proportion of households will have paid off their mortgage entirely and are living in homes with substantial 100% equity. If we look at just that subset of homes which are still subject to a mortgage, the net equity in THESE properties is far lower, shrinking fast, and might even be negative, especially if home prices continue to fall another 10-20%.
There are no separate figures on net equity in the subset of homes against which the mortgage debt and ultimately the bonds are secured. But let’s assume 25% of US households live in properties with no mortgage (typically retired families) and that the value of their homes is typical of the housing stock as a whole. That leaves the mortgaged stock worth 75% of the total, so about $14.571 trillion, against which at the end of H1 2008 there was $10.639 trillion worth of mortgages, leaving net equity of just $3.932 trillion in these homes at end H1.
Home prices have fallen further since then, so net equity is already lower than this, probably by around $300-400 billion, if the recent decline in net equity values per quarter is typical. Assuming another 10-20% decline in home prices from current levels as the economy worsens, most of the net equity cushion behind the mortgage market will have evaporated.
The debt secured on half or more US homes will be worth more than the home itself, with little or no prospect of a quick rebound in housing values to rebuild positive equity. In the circumstances, many households may conclude that it is rational to walk away rather than pay over-the-odds for an asset the price of which has no realistic chance of regaining its former value in the short to medium term. The resulting wave of repossessions would only depress prices further.
So while households might still technically have some equity left in their home, from a collateral perspective, after applying an appropriate haircut, the mortgages are probably worth more than the houses against which they are secured. In that sense, the US housing market and mortgage industry is now bankrupt.
The collective liabilities (in the form of mortgage bonds) are worth far more than the proportion of the housing stock against which they are secured, and the situation looks set to persist or worsen.
The situation is less extreme in commercial property, consumer loans, and other forms of bank lending, but equity coverage there is shrinking rapidly too, as corporate profits weaken, the economy falters and collateral values fall. The US government via the Treasury and the Federal Reserve System have tried to prop up the banking system. But with $10 trillion worth of home mortgages, $2.5 trillion worth of commercial mortgages, $2.5 trillion worth of consumer credit, $3.7 trillion worth of trade credit, and $1.5 trillion worth of security credit, much of it held through the banks or mortgage-pools, the government cannot assume or even most of these debts.
Federal revenues amount to only $2.567 trillion per year, or just $1.932 trillion per year if taxes earmarked for Social Security and Medicare are excluded. The government also has $9.6 trillion of its own debts to fund, with another $600 billion or so already added to that to cover the costs of the bailout and lending operations so far. The United States as a whole has $17.639 trillion worth of overseas assets. But it owes $20.081 trillion to foreigners.
In this context, the country’s now-derated assets are probably worth less than its collected liabilities (both internally and internationally). The United States is now, in some very general sense, bankrupt.
Millions of Americans and foreigners now own debt and other securities which are not worth their face value, and which are not likely to be worth their face value under many plausible states of the world in future. But as millions of Americans and foreigners discover every year, bankruptcy need not be the end.
The normal process for resolving bankruptcies is for a court to ascertain the value of the debtor’s assets, and then mark down the claims of the creditors appropriately, according to some rule about how the losses and claims should be shared out. As part of a full and final settlement, creditors are forced to abandon the full nominal value of their claims in return for recovering at least a proportion of them. Recovering something is better than recovering nothing, and bankruptcy may protect the collective value of the assets better than a forced uncontrolled liquidation.
Thinking about the United States, or at least its mortgage market, as insolvent helps identify the way to resolve the crisis. Just as a bankrupt individual or company can have their debts restructured by the court, and creditors’ claims can be modified, so the US mortgage market needs comprehensive restructuring.
Much of the discussion so far has framed the US financial crisis in terms of “liquidity” rather than “solvency”. The assumption is that the problem is just that banks are not willing to trade with one another and that pouring liquidity into the system will solve the problem. But hundreds of billions have been poured into the system with no discernable effect. I would argue that the problem is now one of solvency rather than liquidity. The problem is not that markets are not liquid, but that the majority of banks and many other institutions are probably now insolvent or close to it, in the technical sense that if they were forced to write down all their assets (mortgages, bonds, loans and other advances) to probable recovery levels, their capital might be insufficient to absorb the losses. There is little wonder that insolvent institutions are reluctant to lend to one another.
The solution is a collective restructuring of the claims. The President and Congress could enact a law compulsorily reducing the face-value of all home mortgages by 20%, or even 30%. Mortgage-backed bonds would be adjusted accordingly. This would have the effect of recognising that US housing assets will probably have to be marked down 20-30% in the long term as the market settles at a new lower level.
It would put many households back into positive equity, and reduce the negative equity for others, improving the incentive to continue meeting monthly repayments. It would cut monthly repayments for all households and thus free up household spending to rebuild decimated pensions and avert a deep depression in economic activity.
It would inflict massive one-time losses on creditors – but most creditors realise they will never collect the full value of what they are owed (which is what is being reflected in the discounts at which mortgage securities are being marked even on a hold-to-maturity basis). It would also give creditors more certainty of collecting what remains (the pervasive uncertainty about the prospects for collection and residual collateral values is one reason why the mark-to-market firesale values have been at just 20-40 cents on the dollar).
Overseas creditors would no doubt be angry about the unilateral repudiation of a portion of the debt, with mutterings about the Bolsheviks. But by reducing teh value of the mortgage backed debt, the US government would reduce its need to fund wholesale takeovers of the domestic banking system and mortgage market, which would require a massive issuance of new Treasury bonds, probably at higher yields, therefore inflicting losses on the holders of existing Treasury bonds, and/or increasing the likelihood of default-by-devaluation.
China and other Asian governments as the biggest owners of US mortgage bonds totalling about $950 billion in their reserves would lose perhaps $200 billion from a restructuring. But it is unlikely that the bonds will ever regain their notional value in any event, so restructuring would simply recognise a loss that already exists. Moreover, restructuring the mortgage loans and bonds would reduce the risk of massive debt issuance, yield increases or default-by-devaluation cutting the value of the much larger pile of $1.5 trillion worth of US Treasury bonds that China and other Asian governments own in foreign exchange reserves.
Whether they like it or not, China and the other reserve accumulators are going to take a hit as a result of the crisis. If their mortgage-backed bonds are not written down, the alternative is that the US Treasury issues a huge pile of new debt, driving up yields and cutting the value of their existing stock of Treasuries; China and other countries have to continue accumulating even more US government paper – increasing their already high exchange rate exposure – or risk catastrophic losses on their current bond holdings; the US tries to devalue its way out of the problem, boosting exports but harming China’s exports; or the US tries to deflate its way out of the problem, cutting government spending to reduce borrowing requirements, but pushing the economy into a deep recession that would also cut imports and hence China’s growth rate.
The alternative for the foreign holders of mortgage backed paper is to accept a compulsory adjustment, try to collect the collateral behind impaired assets, or lend even more money to the US government to fund a bailout programme by buying even more US Treasuries.
There are no attractive options, but compulsory adjustment might not be the most unattractive option. If it worked, it might at least offer greater certainty. Already US Treasury bond yields are RISING as the market fears a future flood of issuance and holders scramble for cash. The other alternative, of course, is a big burst of inflation to erode the real value of the claims surreptitiously, and offer debtors relief.
Inflation has been the solution to widespread over-indebtedness in the past for many countries. But even if the Fed COULD generate inflation amid a contracting economy, that would simply expropriate creditors in a different fashion.
Rather than urging households to keep paying mortgages in order to service the notional value of mortgage bonds which will never be worth the value at which they were issued, it might be better to cut the value of the mortgages and bonds, impose a one-time loss on creditors, and start again.
While the idea of a bankruptcy/compulsory restructuring seems incredibly radical, it is no more than an extension of the idea proposed by Reagan-era Council of Economic Advisers (CEA) chief Martin Feldstein who has suggested allowing households to replace up to 20% of their mortgage debt with new federal government backed loans on the condition that (1) mortgage lenders write off the equivalent amount of their own loan; (2) households would be prohibited from adding to the debt secured against their home (through remortgaging or other equity release loans) until the federal loan was repaid; and (3) federal loans would be recourse loans (ie secured against the individual borrower and not just the home, so borrowers could not simply walk away) and would not be eligible for relief in the bankruptcy courts.
Compulsory restructuring would have other benefits. It would be equitable between borrowers, giving all borrowers relief in proportion to their existing loan position, rather than favouring only those who have borrowed more than they can pay, or having to find mechanisms to screen between those who genuinely cannot pay and those who simply choose not to pay.
Compulsory restructuring would also spread the losses across a wide range of debt holders. It might or might not respect the existing structuring within mortgage-backed tranches. But by spreading losses as widely as possible, it would reduce the hit to each individual institution and improve the survival rate among the lenders.
Rather than having some lenders receive 95-100 cents on the dollar (surviving) and others receiving nothing (pushing many of them into failure) if everyone took a moderate hit of 20% many fewer institutions might fail, increasing the prospect of system-wide stability being restored.
Compulsory restructuring WOULD interfere with property rights; it WOULD change the characteristics of mortgage borrowing forever; there WOULD always be restructuring risk in any loan granted in future, even if only a few basis points. But does anyone still doubt that the world will never be quite the same again after the turmoil of the last four weeks?
Moreover, successful stabilisations ALWAYS inflict losses on someone, usually spreading them across many groups.
Extreme financial instability persists (eg Germany’s hyperinflation) when all groups (creditors and debtors, wage earners, price setters, corporations, households, government, taxpayers and recipients of public money) try to press their claims in full. Stabilisation requires some or all of those claims to be written down – forever.
In the aftermath of a stabilisation after hyperinflation, several classes of assets (typically bank deposits) suffer a permanent loss of value, as the currency is stabilied at a lower level. Exchange rate crises are generally resolved by the semi-permanent loss of the (domestic currency) value for some classes of investors.
The current crisis has destroyed an enormous amount of economic value. Some, perhaps much of it, may have been illusory. Like Japan’s Nikkei-225 peaking at 39,000 and never recovering, and real estate values shrivelling, some of that wealth was an illusion and is gone for good. Stabilisation requires those losses to be recognised and absorbed.
The current situation clearly requires two things: (1) some quantification, however rough, of the MAGNITUDE of the losses; and (2) some losses-sharing mechanism to allocate those losses between borrowers, lenders, banks, shareholders, taxpayers and overseas investors.
Losses will overwhelm the capacity of banks and lenders to absorb them. So some losses will have to be transferred to taxpayers and probably overseas investors as well.
The current debate has obscured this by pretending that everyone can emerge whole. In particular, that the government can buy $700 billion worth of troubled assets, and lend huge sums to the banking system, and expect to get all or almost all of it back. That households can somehow repay all or most of what they still owe. And that the mortgages and bonds and other loans will somehow be mostly repaid. In other words that no one will have to bite the bullet. That seems completely implausible.
Quantification and loss-sharing is now needed. It might not be “fair” and there would be a large element of rather rough justice. But past stabilisations have almost always involved a large measure of claims adjustment (which is a polite way of saying “write-offs”) to succeed.
No one would claim that compulsory adjustment is an attractive option. But in the current circumstances I am not sure what a better one would be. The Fed and Treasury have tried “muddling through” with no success so far. Systemic stress has risen rather than fallen. As the scale of the Fed’s and Treasury’s own lending becomes more evident, their own credibility is starting to fray.
No doubt many observers would argue that compulsory restructuring is too difficult, or too radical. But the question is: what is the alternative?
Even if the markets can find some temporary stability, the massive overhang of mortgage debt will take years to work out and could fuel further problems down the line. Someone will have to take the bullet – the only question is who. Perhaps it is better that losses are widely if crudely shared that as many as possible survive.
This is a provocative piece, and meant to be. I would be interested to know what the less radical alternatives are.
John Kemp, economist
__________
