10.4 Million American Families Slide Toward Losing Their Homes -- Is It Time for Debt Forgiveness?
The rebellious citizens occupying Wall Street shock some people and inspire others with their denunciations of bankers, but everyone seems to know what they are talking about: the barbaric and suffocating behavior of the nation’s largest banks (yes, the same ones the government rescued with public money). Right now, these trillion-dollar institutions are methodically harvesting the last possible pound of flesh from millions of homeowners before kicking these failing debtors out of their homes (the story known as the “foreclosure crisis”). This is a tragedy for the people who are dispossessed. For the country, it is a generational calamity.
“We are in the reverse New Deal,” Christopher Whalen, a savvy banking expert at Institutional Risk Analytics, told me. He meant that events are dismantling the ingenious engine that helped generate America’s broad middle-class. Homeownership was the main driver in accomplishing that great social change. For three generations, people of modest means could buy a house knowing it would secure their place in the middle-class and allow them to accumulate significant savings. If the family held the standard 30-year, fixed-rate mortgage, they were painlessly saving for the future every time they made a payment, acquiring greater equity in the home as they did so. With moderate inflation, the house would steadily increase in value even as their monthly mortgage payments stayed the same. So the cost of housing actually declined for the family, as a percentage of its income. Meanwhile, the accumulating equity became a nest egg for retirement or something to pass on to the kids.
That virtuous process, originated by New Deal reforms, is in peril and has already shut down for tens of millions, especially working-class families whose incomes are no longer rising. As described by the brokerage investment firm Amherst Securities, the housing picture is ugly. Among the 55 million families with mortgages, one in five is underwater—they owe more on their mortgage than their house is worth—or already delinquent. That’s 10.4 million families who are sliding toward failure and foreclosure. Virtually all of them will become renters, since no bank is likely to give them a new mortgage.
As a result, the housing market will remain depressed for years—too many houses for sale, too few buyers. Amherst estimates excess supply of 4 to 6 million in the next six years. Economic recovery may have to wait until that surplus is gone, because the housing sector has always led the way out of recession. The more housing supply exceeds demand, the more prices fall. The more prices fall, the more families get sucked into the deep muddy. The vicious cycle is known in the industry as the death spiral. So far, there’s no end in sight.
Laurie Goodman, a senior managing director and housing-finance expert at Amherst, warns Washington audiences, “There is a cost for doing nothing. You just kick the problem down the road; you don’t solve it. Then home prices deteriorate more and you re-create the death spiral in housing, as lower prices mean more borrowers are underwater.”
Conservatives preach patience and resignation: nothing to do except wait until the destruction ends. Liberals insist this is a solvable problem, if only government would act forcefully.
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There is a solution, and it will appeal to the rebellious spirits occupying Wall Street because it combines a sense of social justice with old-fashioned common sense. It is forgiveness—forgive the debtors. Write down the principal they owe on their mortgage to match the current market value of their home, so they will no longer be underwater. Refinance the loan with a reduced interest rate, so the monthly payment is at a level that the struggling homeowner can handle. This keeps families in their homes, with a renewed stake in the future. It gives homeowners incentive to keep up their payments, because once again they have some equity and the opportunity to accumulate much more.
Some people are morally offended by the idea, and not just bankers. Forgiveness sounds to them like old-fashioned bleeding-heart liberalism. Letting failed borrowers off the hook encourages bad habits, they say, the so-called “moral hazard” of inviting others to skip their debt payments too. Forgiveness does require a measure of sympathy—a sentiment in scarce supply among governing elites. Policy wonks and politicians have been taught by a generation of hard-boiled titans and their business-school apologists to brush aside fellow feeling and focus only on the bottom line. The common good, conservatives claim, is best served by adhering to the unsentimental economics of “me first, never mind the losers.” That pernicious doctrine still reigns in the political culture. It is what the people in the Occupy Wall Street movement are rebelling against.
Forgiving the debtors is the right thing to do, because the bankers have already been forgiven. The largest banks were in effect relieved of any guilt—for their crimes of systemic fraud or for causing the financial breakdown—when the government bailed them out, no questions asked. The Obama administration followed up with a very forgiving regulatory policy that basically looked the other way and ignored the fictional claims on bank balance sheets. Instead of forcing honest accounting and rigorous reform, the administration adopted a strategy of soft-hearted regulation that banking insiders call “extend and pretend”: extend the failed loans and pretend that the loans will be paid off, even when you know many of them won’t. The phrase originated during the third world debt crisis in the 1980s, when the Federal Reserve rescued the same big banks from insolvency, the result of their reckless lending in Latin America.
This time, the government’s rationale for rescuing bankers first was that the economy cannot recover until the financial system is healed. The premise did not prove out—banks revived, at least partially, but not the economy. The same rationale applies, more logically, to failing homeowners. A heavy blanket of bad debt is smothering economic activity. Until the debt is lifted from the housing market and financial balance sheets, the economy is unlikely to regain its normal energies. So debt forgiveness is not just a moral imperative; it’s also an economic necessity.
The largest and most powerful banks are standing in the way of this solution. The Obama administration is standing with them, because bankers and other creditors would have to take a big hit if they were forced to write down the debt owed by borrowers. The banks would have to report reduced capital and their revenue would decline if homeowners were allowed to make smaller monthly payments. This could threaten the solvency of some very large banks—those that have been exaggerating their financial condition, as many market analysts and shareholders suspect. That risk presumably explains why the Treasury Department and various housing agencies try to dodge the growing demands for debt forgiveness. Fannie Mae and Freddie Mac, which guarantee roughly 70 percent of all mortgages and are now virtually owned by the government, have flatly rejected the idea, and so have the Federal Housing Administration and the Veterans Administration.
“It’s sinful, is the word I would use, that they won’t do this,” says John Taylor, president of the National Community Reinvestment Coalition and a longtime advocate for housing.
President Obama seems to be playing a sly double game—protecting banks from sharing the pain while proclaiming sympathy for embattled homeowners. The government, in effect, has been sheltering banks from facing the hard truth about their condition. They may be valuing mortgages or mortgage bonds at, say, 85 cents on the dollar when the true market value, industry experts say, is closer to 25 or 30 cents. That strengthens the case for a general and orderly write-down now: if many of these loans aren’t ever going to be repaid, then the assets now claimed by the banks are imaginary. Plus the banks hold nearly all the secondary mortgages (often equity lines) on the same houses. They are sure to fail too if the prime mortgages are busted.
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The issue of forgiveness has little traction in mainstream debate, but prospects for action are far more promising than cynics assume. I am convinced that the debt-forgiveness question will eventually move to center stage, if not with this president then maybe the next one. If it is not dealt with, the problem will become larger and more destructive. The politics will change when the public realizes that the economy will remain stagnant until banks are forced to a reckoning and the huge overhang of bad debt is eliminated.
My evidence for optimism is a sampling of authorities from the financial system—banking and housing experts, financial economists, even a few investment bankers—who are already calling for debt reduction. Moral sentiment aside, people who know how the financial system works understand the ugly consequences of doing nothing. The industry advocates of dramatic write-downs are not radicals, but the logic of their position has so far been largely ignored by the major media. Active citizens are spreading the word, however. While Lower Manhattan was being occupied, the New Bottom Line, a coalition of community groups, church folks and other networks, was staging daily clashes with big banks around the country. George Goehl of National People’s Action sees the level of direct action and nonviolent civil disobedience rising rapidly among frustrated people of conscience.
Stephen Roach, a Morgan Stanley economist and lecturer at the Yale University School of Management, more or less agrees. “Some form of debt forgiveness would be a clear positive,” Roach told me. “Debt forgiveness is a big deal when so many Americans are underwater and unable to keep up with their payments. Writing off debts would help them build up their savings. The saving rate is up, but not nearly enough. With debt reduction, people would feel less reluctant to spend money on new things. If you can do that, then companies will feel more confident about future demand, less reluctant about hiring more workers.”
Roach thinks the executive branch can engineer dramatic debt reduction with or without the approval of Congress. Fannie and Freddie together hold something like $1.5 trillion in housing loans or mortgage-backed securities. The Federal Reserve has nearly another trillion on its balance sheet. As owners, they could unilaterally grant new, more realistic terms to stressed borrowers. “Government can do this by simply telling Fannie Mae and Freddie Mac to take a write-down on their outstanding loans,” Roach explains. “Then the government can put pressure on the banks to do the same thing. The banks will resist, but they have to go along if the government is forceful enough.”
The Fed can likewise become a major influence for debt reduction, Roach says. Conservative traditionalists would naturally be appalled if the Fed directly aided the real economy of consumers and producers, but that objection was nullified by the financial crisis, when the central bank pumped hundreds of billions into nonbank corporations like AIG and General Electric.
If the Federal Reserve is reluctant to modify mortgages, says Roach, it can easily fund the process indirectly by creating new money and buying bonds issued by Fannie and Freddie, just as the Fed purchases Treasury bonds. “The Fed can assist by buying Fannie and Freddie bonds with the emphasis on reducing principal for the borrowers,” Roach explains. “It would be like ‘quantitative easing’ aimed at debt reduction,” a reference to the Fed’s purchases of mortgage-backed securities, Treasury notes and other assets to stimulate recovery.
Laurie Goodman, the Amherst Securities housing-finance expert, assured the Senate Banking Committee in September that debt reduction is readily doable in the financial and real estate industries. “We actually know exactly what it takes to create a successful modification: reduce principal, give the borrower substantial payment relief and modify the borrower in the early stages of delinquency,” she said.
To illustrate, Goodman suggests that a bank or mortgage servicer could reduce an underwater mortgage from $150,000 to $115,000 with a “shared appreciation” agreement. The homeowner would no longer be underwater and would gain some positive equity. If the property is sold in the future, any appreciation in its market value must be shared with the lender. She pointed out that a major mortgage servicer, Ocwen Financial, is already doing such deals. The creditor will getâ€¨25 percent of any future market gain. In many cases, that sounds like a better deal for the lender than holding on to the bad mortgage and eventually getting nothing.
“I would like to think principal reduction would be a mandatory part of the government’s modification program,” Goodman said. “The Treasury has not let it happen.” Meanwhile, she complained, the government is making it harder for homeowners to get new mortgages despite the sagging housing market. “Almost every single proposed government action has been aimed at further tightening credit availability,” she told the senators.
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Why would the government discourage mortgage lending in the midst of the Great Recession? Christopher Whalen, the banking expert, offers an explanation: if homeowners are allowed to refinance and get a much lower interest rate with a new mortgage, both the banks and government agencies like Fannie and Freddie may lose their best debtors—people who are paying reliably on older mortgages with much higher interest rates. Fannie and Freddie boosted their fees, he noted, in order to make refinancing harder and more costly for homeowners.
“It’s propping up profitability for the banks and propping up profitability inside Fannie and Freddie,” Whalen says. “Without that cash flow, their losses would be higher and the yield on their assets would be lower.” This is subtle exploitation, Whalen suggests, aimed particularly at minorities and lower-income people, who paid a higher interest rate in the first place because they live in “a not quite as nice part of town.” The big banks, he says, “don’t want these high-spread middle- to lower-income borrowers to pay off their mortgages earlier because they represent relatively high cash flow.” Whalen endorses a modest proposal from a mortgage consultant and two Columbia University economists, including former Bush adviser Glenn Hubbard, to encourage refinancing at lower rates by removing some impediments to refinancing adopted by the federal agencies or private banking. President Obama may be considering the idea; he gave it one vague sentence in his September jobs speech.
The trouble with the Hubbard proposal is that it helps only “responsible” homeowners, as the president called them. It does nothing for the 10 million or more who have missed payments and are heading for delinquency, then foreclosure. What’s worse, the Hubbard plan essentially tries to bribe the banks by offering them liability against a mountain of damage claims. That could be worth tens of billions to the bankers.
“The ticking time bomb here is the municipalities,” says Whalen. “When people expect to lose their homes, they stop paying their taxes. So you want to get people out of those homes right now; you want to get someone in that house who will pay the bills. But there’s a couple of years’ backlog on processing foreclosures in New York. If we don’t deal with this, we’re going to have big swaths of the economy where the banks basically are paying the property taxes. You don’t want that to go on too long.”
Rob Johnson, a former banker and former investment partner with George Soros, now heads the Institute for New Economic Thinking (INET). He endorses debt reduction because social destruction is the great uncalculated cost of doing nothing. “There are so many communities that are being unnecessarily destroyed right now,” Johnson says, “not to mention pension funds and insurance companies holding mortgage securities that are trading at lower value because the destruction is damaging the property. We are in a really weird place where the whole economy—the reallocation of resources, the quality of communities, the funding of municipalities, all of it—is blocked by the banks doing ‘extend and pretend.’ ”
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The American financial system seems ultramodern in its complexity, but it is actually ancient in the brutal ways wealth asserts power over others. The earliest societies were torn by conflicts between lenders and borrowers, the rich versus the poor. They were compelled to fashion hard rules and put restraints on lending to curb the cruelties and promote a moral minimum for social justice. Nearly every country and culture embedded these values in religious tenets that governments enforced. Anthropologist David Graeber asserts provocatively in his book Debt: The First 5,000 Years that the power struggles over debt were probably the starting point for developing civilization’s moral codes.
The arguments typically began when kings or landowners lent some of their surplus wealth to peasant farmers, then took away the debtors’ property if they failed to repay the loans. In olden days, the creditor would seize the debtor’s livestock and vineyard, perhaps even his children to be enslaved as household servants, until the debts were repaid. If the failure of borrowers persisted, the wealthy lenders would wind up owning all the property, with the peasants reduced to tenant farmers on the land they had once owned. The negative cycle stopped when the peasants could no longer borrow because they had nothing left for lenders to claim in default.
Economic life at that point was frozen or depressed, no longer functioning. In a rough sense, this resembles what happened to our economy in the financial crisis. Debtors were tapped out, up to their eyes in debt, and creditors recognized that they could not lend to them anymore without losing their money. In modern economies, no one takes away their children, but they do seize homes and cars and other assets.
The ancient Hebrew society worked out a solution for recurring debt crises—you can find it in the Bible. Every seven years (in some interpretations, every fifty) the cycle of debt accumulation was erased by a declaration of general forgiveness. This was called the year of jubilee, and Christianity embraced the same moral principles (“forgive us our debts, as we forgive our debtors”). Property was returned to the original owners, and children and slaves were freed. Everyone was redeemed. The economy was freed to start over again.
Graeber thinks Judaism’s reform laws were probably influenced by the Babylonians, who issued “clean slate” edicts when excessive debt accumulation threatened social crisis. Graeber notes that nearly every society, ancient and modern, shares moral confusion about debt, with contradictory attitudes. On the one hand, “Paying back money one has borrowed is a simple matter of morality.” On the other hand, “Anyone in the habit of lending money is evil.” Americans share this ambivalence.
Here is what Americans can learn from the ancients: severe inequality of wealth and income is not just a question of morality. Inequality is the fundamental source of the disorder that leads to financial crisis and chokes off the economy. Ancient religious principles like the limits on interest rates were a practical way of maintaining balance in economic life. Taking away those rules—as US politicians did when they repealed prudent regulations of banking and finance—in effect authorized the growing inequality that eventually leads to chaos.
Modern economists and their supposed “science” generally ignore the ancient wisdom. Most would probably dismiss the connection as folklore. Some economists study inequality and what drives it. Others study financial fragility and macroeconomic volatility. But the two subjects are seldom addressed as underlying cause and effect. Gross concentrations of money at the top help explain why the system eventually stalls out. This is a basic insight that ought to inform the agenda for recovery. Inequality matters.
Economists Michael Kumhof and Romain Rancière wrote a breakthrough paper for the IMF that made the connection between inequality and financial crisis. “The crisis,” they wrote, “is the ultimate result, after a period of decades, of a shock to…two groups of households, investors who account for 5% of the population, and whose bargaining power increases, and workers who account for 95% of the population.” The 5 percent, broadly speaking, lend to the 95 percent, and in so doing gain still greater wealth and power. The shock comes when the creditor class suddenly realizes that the borrowers are drowning in debt and cannot possibly absorb any more. At that point, financial assets connected to consumer debt are dumped and prices crash, much as they did in 2007. The authors add, “To our knowledge, our framework is the first to provide an internally consistent mechanism linking the empirically observed rise in income inequality…and the risk of a financial crisis.”
It took three decades of lopsided borrowing to produce the breakdown, Kumhof and Rancière explain, but the ominous trend was evident for years. In the early 1980s the 95 percent had debts equal to about 65 percent of their income. By 2006 that figure had risen to 140 percent. They were devoting so much of their paychecks to making payments on old debt—credit cards, equity lines and mortgages—there was nothing left to make the payments on new debt. Defaults and bankruptcies were already swelling. The collapse came when creditors grasped the danger and started selling off their mortgage bonds and loans to consumers.
It seems odd that the financial interests, with their brilliant analysts and high-speed computers, didn’t see the nature of the crisis until it was breaking over their heads. They may have been blinded by the fabulous wealth they were harvesting. Kumhof and Rancière point out that the same ominous combination—a run-up of debt accompanied by gaping inequality—preceded the crash of 1929. Greed may inspire optimism.
But why did ordinary debtors fall into this trap? The standard line is that they, too, were blinded by greed, eager for consumer pleasures they couldn’t afford. This is true for some, but the explanation libels most working people. Wage stagnation started in the 1970s and spread widely in the Reagan era. Typically, as incomes faltered, families faced two bad choices—either go deeper into debt or surrender their middle-class standard of living. Naturally, most people tried to hang on to what they had.
The responses to this crisis are well-known. People worked more—women and teenagers entered the workforce, family members took two or three jobs. And they borrowed more, paying the bills with credit cards. In these terms, average families were making heroic efforts to maintain their standard of living. They were doomed to fail unless dramatic economic reforms improved their lot. University of California economist Clair Brown predicted nearly two decades ago in her landmark study of American consumption that sooner or later working people would have to retreat to lower levels of consuming. Working harder and borrowing more had sustained them for twenty years, but neither of these remedies was repeatable. At some point the merry-go-round would have to stop.
The retreat is now in full flight. Homeownership has declined by 1.1 percent over the past decade. Wages are stagnant or falling. Foreclosures are tearing through communities, and falling home prices are destroying family equity. Americans, as Whalen says, are experiencing the reverse New Deal.
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The president is losing the policy bet he made at the outset of his administration. Government regulators, he decided, would give leading banks a pass on stern cleanup and rigorous reforms. With blanket forbearance and enormous lending supplied by the Federal Reserve, the assumption was that the largest financial institutions could earn their way back to solvency, gradually shedding all those “toxic assets” left over from the collapse of the housing bubble. Recovery of the broad economy was supposed to follow.
Obama’s bet looked very much like the one Japan made in the 1990s, after its spectacular housing bubble burst. Obama’s failed just as Japan’s did, and for some of the same reasons. Neither nation wished to take on the biggest banks or do something about the mountain of bad debts suppressing new economic activity. If Japan is the yardstick, the United States is in for a long, slow drag of ten to fifteen years. Japan spent a fortune on stimulus in the form of infrastructure spending, which probably helped, since unemployment never got above 6 percent. But its federal debt has risen to more than 200 percent of GDP, and the country is still demoralized by a soggy economy.
“Let me tell you the basic parallels,” says economist David Weinstein of Columbia University. “The United States and Japan both have big debt overhangs as the economies slowed. Both tried fiscal policies, which were probably held back by fiscal conservatives. At least in the Japanese case, that stimulus really was working. The mess in the banking sector fed into manufacturing and many other sectors. Instead of lending, the bankers were trying to reserve that money to cover their losses, trying to hide their losses. All of that was going on.” Like other experts, Weinstein believes there will be a second banking crisis in the United States.
Obama hasn’t changed his failed strategy or relieved the advisers who sold it to him. But the original plan has come back to haunt him. If he tries to act now, he will face a new dilemma: can government act aggressively to force reform and restructuring on the biggest banks without triggering insolvency for some of them? The alternative is to keep bumping along with stagnation or to foster inflation as a way to reduce the value of old debts and ease the pressures on debtors. Either promises bitter controversy. Rob Johnson, the former banker now at INET, thinks government will eventually have to intervene decisively to clear away the rubble and restart the economy.
The country needs a bank holiday somewhat like the one FDR ordered in 1933. “We basically have four banks and two investment banks that now call themselves banks [JPMorgan Chase, Bank of America, Wells Fargo, CitiGroup, Goldman Sachs and Morgan Stanley],” Johnson explains. “These institutions are so intertwined they are a system. You can’t deal with one bank alone; you have to deal with the system. You call a monthlong bank holiday for the twenty largest banks, and that holds everything in place while the regulators mark down the assets and see how everybody’s losses will affect everyone else.
“Then you wipe out stockholders, wipe out management, possibly some of the unsecured debt. Mortgages would be refinanced based on real value. Once everybody has taken their hit and you’ve wiped out existing stockholders, then the government comes in and properly, transparently recapitalizes all of them. As these new institutions gain a footing, eventually they can be sold back to the private market.” This is rough stuff, but the nation could get a fresh start and a new banking system out of the hard knocks. Think Jubilee, American style.