Rethinking Bretton Woods | Tue, Jul 24, 2012
The article looks at an innovative proposal being considered by San Bernardino County authorities to respond to the ongoing mortgage market crisis in the US.
San Bernardino county authorities are reported to be considering a measure that could dramatically change the outlook for the US economy… if only it was implemented in a wider scale.
With growth forecasts being revised downwards for almost all countries in the world,[i] and major downside risks threatening those projections, no task would seem more urgent than finding innovative ways to provide stimulus to the global economy. Sadly, it is the opposite, a misguided drive towards austerity, what prevails in policy-making circles. The Group of 20, meeting in Los Cabos, Mexico last June, settled for a timid call for advanced economies to “ensure that the pace of fiscal consolidation is appropriate to support the recovery, taking country-specific circumstances into account and… address concerns about medium term fiscal sustainability.”[ii]
The political limitations on the fiscal front have forced monetary authorities to take action to provide the needed stimulus. But there are growing signs that those tools are running out of steam.
The limited impact on the monetary front is due, in no small part, to the continuing real economy problem of high household debt. This has prompted economists such as James Galbraith to recommend household debt restructuring as one of two key measures to exit from the crisis.[iii]
For instance, due to monetary policy easing in the US, it is calculated that 20 million borrowers should be in a position to refinance their mortgages, thus freeing more money to boost demand. Yet, the fact remains that too many of them cannot access refinance options because the slump in housing prices left them without enough equity in their homes.[iv] The limitations that the housing market poses to monetary responses are also addressed in a report by the Federal Reserve Board of Dallas. Recalling that much modest monetary action has had much more impact in the past, the report goes on to say that falling housing prices have been a lingering drag on the economy.[v]
Against this backdrop, it is perplexing that a measure considered by two cities of San Bernardino county (“San Bernardino proposal”), Ontario and Indiana, is not receiving a lot more debate and attention. This proposal offers a promising approach whose potential for replication at a nation-wide scale, either by the Federal government alone or in partnership with State and local governments, should not be neglected.
The measure being considered by San Bernardino county would apply to mortgages that were bundled together and backed securities that were then sold to investors (in that sense, it would not apply to mortgages currently held by banks). It would identify mortgages that are underwater –where the loan balance exceeds the property value-- but where borrowers are current in their payments. The government (in this case the local county government) would use its eminent domain to remove the mortgage from the pool paying a market price and restructure the mortgage to match the size of the current property value. Mortgages thus restructured would be then pooled together, securitized and, with a government guarantee, sold to new investors at a market price (likely higher than what was paid to the original holder).
Eminent domain is the right that assists the state to take private property – an act also known as “condemnation” - for public use by virtue of the superior dominium of the sovereign power over all lands under its jurisdiction. While eminent domain is more frequently used to justify seizures of real estate, it is not really limited to them. Securitized mortgages tend to have legal stipulations preventing the holder from selling other than at face value. Therefore resort to eminent domain would be the only way for the government to buy them at fair market value.[vi]
What makes the program so appealing is that it is actually hard to identify any stakeholder who can reasonably be unhappy with its outcome.
A large number of underwater borrowers would reduce their debt and monthly expenses. Some experts point to an approximate 12 million households in the US that could be in a position to benefit from such program.[vii]
Investors who hold those mortgage-backed securities get a decent out from what proved a misguided investment decision, without facing any more risks or the potential costs of going through a foreclosure process. The lax due diligence standards by investors in pooled mortgage-backed assets is one of the well-documented factors that allowed the buildup of a housing bubble and consequent crisis. Holders of these assets would not only be spared any sanction, but actually get a partial bail-out, hence having little ground to complain.
Banks also stand to benefit. The loans the program would propose to seize are, as explained, not those held by banks. But the reduction in unnecessary foreclosures will limit downward pressures on prices for all houses in the target market, helping the performance of bank-held mortgages, too. Not to mention the indirect effects from job creation that can save many more mortgages from falling in default. This would not be the first case of the lenders’ bottom line soaring because of programs designed to support borrowers.[viii] But at least banks are helped as a collateral benefit of relief provided to lowest income households, rather than as a primary target of bailouts whose benefits may entirely bypass low income households. Overall, banks should be happy about this.
But the bigger gains are for the economy at large, which would receive a boost as the freed disposable income of millions of homeowners fuels aggregate demand. This effect would be enhanced because the program by definition would transfer funds to those with higher propensity to consume.
Some may criticize the measure as an intrusive level of government intervention. But, to put things in perspective, one could point out that in a publication early this year the IMF recommended as good practice an approach involving a lot more intervention than this, and that was deployed by the US to deal with a similar problem after the 1930s Great Depression. In that publication the Fund, recognizing the seriousness of the housing problem worldwide and reviewing a number of different approaches, stated that “Bold household debt restructuring programs, such as those implemented in the United States in the 1930s and in Iceland today … help prevent self-reinforcing cycles of declining house prices and lower aggregate demand.”[ix]
The US Home Owners Loan Corporation (HOLC) established in 1933 by the US government bought distressed mortgages in exchange for bonds with federal guarantees on interest (in 1934 it was widened to cover also principal). Then restructured the mortgages to make them more affordable and worked with delinquent and unemployed borrowers to help them find jobs.[x]
The San Bernardino proposal represents a far lower level of government intervention. For one, the San Bernardino proposal does not give current mortgage-holders government bonds, but would pay money to them. Second, the government does not keep the mortgages, but sells them at a market price to a new investor. Yes, it enhances their value with a government guarantee and with the increased creditworthiness of borrowers that are in better position to pay, but does not keep the mortgages for a long term as the US government did in the HOLC. Third, contrary to what the HOLC entailed, there is no job support program for homeowners accompanying the San Bernardino proposal– and this is actually a regrettable limitation in the latter, but worth noting as a concession for critics of “big government.” Fourth, the cost of the HOLC total mortgage purchases –resulting in the restructuring of 800,000 mortgages – amounted to an 8.4 percent of GDP.[xi] The San Bernardino proposal does not involve any new debt, but a contingent liability for the government on mortgage defaults – defaults on loans that would have had hitherto zero default rate, that is even before restructuring to reduce the loan-to-value ratio.
In an economic quagmire that every day seems to have fewer exit routes, disregarding rare win-win, innovative stimulus proposals is not a luxury decision-makers can afford.
[i] OECD 2012. Economic Outlook. May; United Nations 2012. World Economic Situation and Prospects. Update as of mid-2012.
[ii] See further analysis of the G20 Los Cabos Summit outcomes at https://www.coc.org/rbw/g20-bailed-out-european-crisis-july-2012
[iii] Galbraith, James K. 2010. On the Economics of Deficits, in American Prospects, October 11. The other measure he recommends is “a reconstruction of the banking system, purging the toxic assets from bank balance sheets and also reforming the bank personnel, compensation, and other practices.” Needless to say, measures for the housing market would also help in unloading toxic assets.
[iv] Nasiripour, Shahien and Tom Braithwaite 2012. Low rates not reaching many US homeowners, in Financial Times, June 21.
[v] Federal Reserve Board of Dallas 2012. Annual Report 2011.
[vi] According to Cornell Law Professor Robert C. Hockett, as quoted in Lazo, Alejandro 2012. San Bernardino County Weighs Eminent Domain to Fight Foreclosures, Los Angeles Times, July 6.
[vii] McCrum, Dan 2012. San Bernardino takes on US housing slump, in Financial Times, July 13.
[viii] It is reported that lenders stand to gain some USD 12 bn from the Home Affordable Refinance Program (HARP) while homeowners that were actually targeted by the program would save between USD 2.5 and 5 bn. See Berthelsen, Christian and Alan Zibel 2012. Borrower Aid Boosts Banks, in The Wall Street Journal, June 18.
[ix] IMF 2012. World Economic Outlook. April, at 114.
[x] Ib. at 105-6 and Box 3.1.
[xi] Ib, at 106.