Borrowers in Europe remain highly leveraged. This is the verdict of the IMF documented in the UK by the Bank of England in its November 2013 Financial Stability Report where they note a UK debt-to-income ratio of 140 per cent (Chart 2.4). Mortgage debt represents a substantial proportion of this debt and reports in late 2013 outlined the vulnerability of homeowners to an interest rate rise. The IMF recommended that European governments might consider ensuring that they have ‘effective insolvency frameworks—featuring, for example, fast and flexible personal insolvency’. Joseph Spooner and I in a recent post criticised the current English system (Scotland has its own system) as failing to provide effective and widely accessible mechanisms for swift deleveraging.
Against this background has appeared a new book on the causes and policy responses to the Great Recession by Atif Mian and Amir Sufi entitled House of Debt. Lawrence Summers described it in a recent FT review as perhaps ‘the most important book to come out of the 2008 financial crisis’. Mian and Sufi find (on the basis of careful data analysis) that the severity of a recession is linked to the preceding build up of household debt (‘economic disasters are almost always preceded by a large increase in household debt”). Those countries with the largest build-up of household debt suffered the largest decline in output. The collapse of asset prices concentrates losses on borrowers with lower net worth whose spending is most sensitive to income shocks. This intensifies inequality. Given this diagnosis policy makers should ensure swift deleveraging for these debtors. This policy prescription challenges the dominant economic view that the banks must be protected (i.e. bailed out) ‘at all costs’—what they term the ‘bank lending’ view— in order to sustain lending and in priority to bailing out homeowners. A higher priority should have been given by governments in the wake of the Great Recession to reducing the debt of those lower and middle-income consumers with ‘the highest propensity to consume’.
Mian and Sufi also argue that ‘moral hazard’—that individuals will run up debts and take more risks because of a possible bail out–are greatly overstated. Individuals may have mistakenly believed in a continuing increase in house prices and assumed that because their neighbours continued to borrow against rising values that it was not dangerous to do so, but this is hardly moral hazard.
Mian and Sufi’s diagnosis is clearly an important economic intervention. I am interested in the consequences for policy making. They critique the Obama government for failing to permit the writing down of principal (so-called ‘cramdown’) on mortgage debt in US bankruptcy law and for its ‘tepid’ programmes for over-indebted householders.They also criticise Spain where the government made little attempt to protect homeowners and only under pressure from civil society, the European Court of Justice, the European Semester and the IMF, introduced reforms and ultimately in late 2013 a very limited form of insolvency for non-traders (see discussion here).
No overall assessment exists of the European response to households with unmanageable mortgage debt, after housing bubbles burst in countries such as Ireland, Spain and the UK, and the subsequent imposition of austerity severely depressed growth with consequent household debt problems in Greece, Portugal and the Baltic states. Although the EU commission in the documents accompanying the Mortgage Directive indicates that ‘losing the family home after having lost one’s job has intolerable social and human implications for both borrowers and their families’, the Mortgage Directive has rather mild provisions on mortgage arrears (see art. 28) encouraging member states to promote forbearance in foreclosures. Given the absence of non-recourse mortgages in Europe individuals cannot ‘walk away’ from negative equity and in countries such as Spain could not discharge the unsecured part of the mortgage in bankruptcy since a discharge was not available to non-traders.
The EU provides a laboratory of national experiments in writing down household debt. These include (1) moratoria on foreclosures (Iceland, Greece) and foreclosures as a last resort (UK) (2) protocols for identifying and treating consumers in arrears on mortgage debt (UK, Portugal) (3) Possibilities for restructuring mortgages and foreign currency loans (Hungary) and in some cases write-down of the principal (Iceland) (4) Buy backs by local governments or agencies and rental to debtor (5) State subsidy for mortgage interest (UK).
European precedents from previous crises existed for addressing mortgage debt. After the banking crisis in the early 1990s, Norway instituted an apparently successful programme of principal write-down with lenders having the possibility of recouping a portion of any subsequent upswing in value. Iceland introduced a similar programme after the crisis which received praise from the IMF in its 2012 World Economic Outlook report (see ch 3). This report recognised the importance of ‘bold household debt restructuring programs’ and commended Iceland for having introduced an integrated set of procedures which combined standardised methods for mortgage renegotiation with targeted relief of principal write-down for those with negative equity.
In contrast the Greek reforms of 2010 which included mortgage restructuring as part of insolvency and an across the board moratorium on foreclosures were regarded by the IFIs as a failure partly because of the inadequate court structure and absence of clear guidelines. The law was modified in 2013 to provide more targeted relief for homeowners.
A central policy question is whether to address mortgage debt within bankruptcy procedures or to establish separate, and usually temporary, programmes. Few homeowners make use of existing insolvency procedures in the EU, even in those countries where it may be possible to deal with aspects of mortgage debt (e.g. France–where there is a discretion to write-down a deficiency on housing debt) and this may suggest that separate programmes have better chance of success. In contrast in the US an influential article by Adam Levitin in 2009 argued that the well-established US bankruptcy procedure with specialised bankruptcy courts was the best site for dealing with mortgage debt. The US government did not however adopt this alternative and a subsequent study by Alan White and Carolina Reid suggests greater success was achieved through specific loan modification programmes than through existing bankruptcy procedures.
Further systematic empirical study in Europe is desirable. Existing experience suggests difficulties in achieving well-balanced programmes during a crisis. In his review Summers criticises Mian and Sufi for not taking these practical difficulties into account but Levitin argues in a response to Summers that these difficulties were overstated or non-existent in relation to cramdown.
Political challenges exist to the introduction of any cramdown programme. Financial institutions in countries such as the US and UK remain influential in a crisis and are unlikely to support mortgage principal write-downs. Conflicts over policy may result in compromised and poorly designed outcomes. It could be useful therefore to plan ahead for potential trouble before a crisis occurs. Mian and Sufi suggest greater risk sharing of downside risk in debt contracts so that they resemble equity contracts (similar to Islamic finance). Thus a shared responsibility mortgage would offer downside protection to the borrower through reduced mortgage payments if the value of a home decreased while the lender would take 5 percent of any capital gain. This would produce an automatic stabilizer during recessions through reduced payments. Without discussing in depth the details of this programme it has the benefit of attempting to address ex ante potential problems by providing an automatic stabilizer in the event of a crisis.
Home ownership is an important economic and social institution in the EU. Before deregulation in the 1980s, the UK had a ‘safe’ mortgage system with a low repossession rate because access to mortgages was limited for ‘non-standard’ individuals. The French system of financing home ownership continues to limit access to younger individuals and those not in secure jobs. The consequence is a default rate much lower than in the UK (see discussion here ch.4). The current recession underlines the need for effective safety nets for individuals in economies subject to periodic housing bubbles.