Republicans have a Janus-like attitude towards public deficits. When Democrats hold office, deficits suppress business investment. Otherwise, deficits can boost industrial output, especially defense. Democrats migrate towards a financing perspective, where debt loads depress expectations. But the world loans the U.S. government at almost nil. This isn’t a subprime loan; U.S. treasuries lock down rates. While economists dig into future scenarios to detect fatal flaws in big deficits, they miss the debt that really matters.
Distressed mortgages, high balance credit card accounts, ballooning home equity repayments, and monstrous student debt weigh more heavily on U.S. GDP growth than government deficits. Simple arithmetic shows that in half a decade, $1 borrowed by consumers at 12% costs $1.75 to repay, while $1 lent to the government at 2.5% owes $1.13, less than a quarter of the interest. Since consumer spending drives the U.S. economy, the medium term threat of personal insolvency causes plenty of business indecision; the threat of government insolvency is remote.
Legislation can address consumer debt. It should be front and center in public debate, yet there’s little evidence of this. Part of the reason may be that consumers are too important to frighten, especially given the moralistic tendency of many pundits. Also, its probably important that concrete measures to ameliorate consumer debt require the finance sector to cut profit margins. Even if it can be demonstrated financial conditions will be better off after that sacrifice, short-term incentives force bankers to resist.
In science and economic policy, accuracy or truth isn’t found by splitting the difference between extremes, or the loudest voices. Medicare and Social Security do not drive deficits over the next decade; Bush-era tax cuts and the economic downturn do. A paper by the Center on Budget and Policy Priorities analyzes this from a neutral perspective. Yet today’s cacophonous debate drowns out reasonable data.
We must be careful what we wish. While citizens may demand government services selfishly, government spending on education, infrastructure, basic research, along with poverty reduction and public safety, have beneficial economic impact. These “discretionary” items will be the most likely cut in the current environment.
It isn’t very meaningful to compare how families and governments handle budgets, but today’s pundits do so regularly. Politicians and media say excess debt hurts credit ratings of individuals, companies, and states, as if these are similar. They overlook revenue, which should determine appropriate debt. A family’s revenue comes from wages and investments — for most, wages — supplemented by high-interest credit. A corporation’s revenue is earned, but much of its cash flow is commercial paper, short-term bank credit — not unlike personal credit cards, but without the high APRs. A government’s revenue comes from taxes, fees, tariffs, and investments — mostly taxes — supplemented by short and long-term treasury borrowing.
In each case, debt is loaned with less risk if the bank or investor expects the client to have adequate future revenues, be they wages, sales, or taxes. Clearly, credit cards and treasury bills carry different risk, given their interest rates vary by a factor of 10. Comparing families and the state requires appreciating this difference. If wages stagnate, families hurt. But a government’s tax base will get bigger with population growth, even if wages don’t increase. U.S. tax rates can be raised if alternative uses are less economically valued investment or consumption. But the media communicates U.S. demographic data through the lens of immigration and ethnic change, rather than as an economic imperative. It lets one extreme view of taxation’s opportunity costs speak loudly, namely those who claim private investment and consumption always trump government spending.
While personal credit costs weigh heavily on future consumer demand, and depress many people’s willingness to pay taxes, the nation’s cost of credit is almost negligible. Consumers hold America’s most important debt right now. Credit card, home equity, mortgage, education, medical, auto, and other personal debt can increase or reduce demand for U.S. businesses. If consumers and credit providers have confidence in people’s future income streams, debt stimulates demand. But if the reverse is true, and doubt in future opportunities is stronger, overhanging debt reduces demand.
That’s today’s condition. Lack of demand extends the current economic crisis, which should make consumer debt a policy priority. Much of it carries very high interest rates, to both dampen consumption and increase borrower risk.
Personal credit exists because wages, employment patterns, and annuities come in periodic pulses. Wages get paid weekly, bi-weekly, or monthly; those with contracts may get paid once or twice, three months apart, while professionals depend on billing cycles. Very few people collect 1/30 of a month’s income every day. But most of us consume a fraction of a month’s food, fuel, and other living expenses on a continuous basis.
Credit fills the gap between low frequency income periods and high frequency consumption periods. Since a person’s cash flows converge over extended periods, creditors can expect a person to pay off loans over extended time-frames. They take that risk for an interest charge. Examining borrowers employment patterns, projected wages, and assets is too much work for credit cards. Instead, card companies use credit bureau scores that primarily analyse a person’s repayment habits.
Loan payment history, in theory, expresses a person’s ability to borrow and repay. A credit card company may find repayment analysis relevant for customer scoring. Repayment history presumably derives from seven year’s income and spending patterns, weighted towards recent behavior. These scores do not capture longer-term income and behavior sequences, a critical cause of the subprime loan crisis.
Asset purchases, like houses and autos, and human capital investments, like college and travel, flip the consumption process around. Instead of credit for something immediately consumed, loans for a house, car, or college degree are for something in use, to be used, and perhaps maintained and salable. In theory, the loan company determines the asset’s necessary repayment schedule, sees if a borrower’s cash flow matches up, and examines collateral and transaction costs. But banks and other asset lenders often apply scoring that credit cards use, a window on recent consumption repayment reliability — rather than income and employment trajectories, and habits that change over a person’s life-span.
Much as S&P, Moody’s, and Fitch can err in determining corporate or government risk, which can cause economic calamity, the three personal credit bureaus can misread personal credit risk, with very dramatic aggregate consequences. But this isn’t on the media radar.
Wall Street and big banks get benevolent government loans to avoid bankruptcies that would freeze business credit and damage the economy. Small businesses teetering on failure don’t get this option; individuals who face potential defaults on mortgages or card balances are not just ignored, federal law criminalizes them to an extent that they may never recover from. But the aggregate debt of consumers, or small businesses, causes great economic upheaval, as dramatic as a too-big-to-fail banks. If personal debt is a huge economic drag, policy should pay it lots of attention. But neither legislators nor the media show this inclination.
If 30-year old Bill bought a $500K house in 2000, with 10% down on a 30 year mortgage at 8%, the lender expects a 30 year sum of $1.25 million. In 2008 the house was valued at $300K, and interest rates were 5%. In 2006 Bill quit his job for a start-up that failed as the recession started. In 2008 he was unable to pay the annual $40K mortgage. Now 38, he’s paid the bank $350+K so far, more than the house is worth. If he walks away, the bank has already recouped its loan, but Bill has less than nothing. Friends say the bank should refinance his loan at a 5% interest rate, which could reduce annual payments to $30K, which is manageable on his wife’s income. Interest payments for the next 22 years would be reduced around $200K, so the lender gets $1 million, which seems OK. But the bank sliced and diced mortgages and sold a tranche to someone for the last 20 years’ interest: that single tranche may get hit the full $200K. The bank worries about litigation.
If Bill walks away from the house, that tranche still doesn’t get paid. After walking away, every tranche, not just the last, could get hit. The bank worries about that, too. Two possible legislative options exist. Make sure walking away is painful, the hammer homeowners option, so they suffer enough to stay in their house. That’s wishful thinking combined with cruelty. Or legislators could make refinancing more flexible, by altering bank liability. That’s practical, but would hurt speculators with high-risk security tranches.
Interestingly, banks have long argued that allowing mortgage modification would increase average mortgage costs. In fact, they take the issue quite personally. Their lobby labelled such modifications “cramdowns”, a pejorative term used in corporate bankruptcy when debt, bond, and share holders are forced to suffer heavy losses. Banks who offloaded subprime mortgage tranches onto special equity markets should, in theory, welcome reducing their liability to these tranche holders, in exchange for mortgage flexibility. Unfortunately, banks did not offload these risky mortgage pieces uniformly; not surprisingly, it was easier to market the more credible stuff. Also, large institutions have an overriding concern for transaction costs, especially regarding wide-spread litigation.
If a finance company writes mortgages using minimal human effort, based on credit scores, reported income, family status and the like, after ten years they have a large portfolio. The unit may have 50% of its staff dedicated to filing mortgages, many who work for bonuses awarded by volume. In year ten, 1/3 of the mortgages show distress, and mortgage demand drops. The company lays off half of the mortgage filers. To review and modify a distressed mortgage takes twice the time of filing a new one. If distressed mortgages must be reviewed and possibly modified, half the original workforce has to accomplish what took three years to file, and will take twice the time to modify. Hypothetically, it could take 12 years, by which time few original homeowners will be in their homes (because they were unable to maintain their payments).
To lower the average cost of mortgages, Congress has repeatedly closed the opportunity for bankrupt homeowners to renegotiate mortgages in court. By prohibiting mortgage modification, banks said they could lower rates, though valid bankrupts (due to disability, breadwinner death, unforeseen events) were forced out of homes. Because of the housing crisis, some suggested reviewing these restrictions, but banks said any rule change regarding mortgage modification would cause them to restrict new loans, claiming the uncertainty produced by changed mortgage payments would upset investors, and raise bank costs. Finance industry pressure was applied, and Congress avoided the issue.
Banks and reputable financial firms do not profit from foreclosures. They may break even, but it’s a poor business model. When they can churn out new mortgages, and reward executives handsomely, while trying to unload risk, the short-term looks bright. If they can escape prosecution and protect those bonuses from clawbacks later, the downside seems modest. But it isn’t a good business model for investors or society. Instead of demonizing mortgage bankers, although some may deserve prosecution, it’s sensible to consider a better model.
The discussion of mortgage debt often revolves around short-term individual and business behavior. Conservative economists like Todd Zywicki believe homeowners misuse bankruptcy as a gimmick to avoid paying debt honorably. Many homeowner advocates see it differently; illness or job loss forces good citizens to lose everything. The huge backlog of foreclosures strains the housing market, depressing construction. Libertarians want people out of those foreclosures, to “clear the market”. Bankers hold the backlog and worry that a glut of foreclosures will cost them dearly. Each group seems to have a different short-term view. But mortgages, by definition, are a long-term product.
Capitalism’s actions often get summed up as businesses reponding to consumer wants. From the marketing and revenue desks, this looks right. But taking a wider view, companies develop structures — plans, procedures, and people in particular places who use resources to produce things and information. To sustain and grow, they serve a function. Functions can seem like wants, as when Apple serves the computing function of its customers by molding a tablet’s edges ergonomically. From a larger perspective, even Apple customers say they buy computer devices to get informed and communicate. iPads provide asthetic and status pleasure, but without doing the communication/information thing, they’d wouldn’t exist. Long after tablets are antiques, and Apple has become a company that makes nano-scaled brain implants, people will need to get information and communicate. These are functions, and companies like Apple are structures that serve them well.
Mortgage companies are structures that serve a function, namely the need for people to access homes without the endowment to pay upfront for them. Unlike groceries put on a credit card and consumed quickly, people anticipate using a home for many years. They can invest time, labor and resources to maintain and improve it, because they will benefit when they resell the house in the future. Or they can let it rot, and pay the price later on.
A house is so much more expensive than people’s usual income streams, the mortgage splits payments over nearly half a life-time. Someone 30 years old will pass through several life phases over this time. In the U.S., people consume the most in their mid-40s, when they have to care for children, spend on school, look after aging parents, etc. In their 50s they save. Americans, on average, change jobs every four to five years; the mortgage period covers six different jobs. Income often drops when they switch, to pick up later. Most important, the average U.S. business cycle takes seven years to repeat; at least four full booms and recessions over a 30 year mortgage.
U.S. boom and bust cycles, to anyone who pays attention, have gotten much larger. It’s understandable; to the extent they are driven by demand, more people buy things every year, since population rises. So expect business cycles to get bigger, both on the upside and down. Four hefty business cycles should occur over today’s 30 year mortgage period.
Information this important would be a primary focus of mortgage economics, but it’s not. During economic recessions, if people lose jobs and start new ones at lower wages, and if they are at an age when family needs rise, they can still reduce grocery, vacation, and transportation expenses. But a 30 year mortgage is inflexible. Yet the 30-year period is realistic, because people use a home for that long.
If mortgage companies serve people’s wants, they can get away with providing low introductory rates and future balloon payments to people without much income. People want housing. The rest of us should remember mortgage companies serve a function, not just a want. The function is to obtain housing for people by spreading payments over half a lifetime. This makes the house affordable, and may be around the length of time they live in it. But over that time frame both families and economies go through big changes, with ups and downs. As cycles rotate more aggressively, the mortgage function should adjust. It’s no longer enough to spread payments over a long time; they need to go up and down with the ebb and flow of a more violent macroeconomy.
Today many homeowners are now trapped in a downward spiral. Given adequate support, most could emerge much better off in a few years. But the banking industry is terrified of change, especially with mortgages that have been sliced and diced and sold off.
The CBO scored a Chapter 13 modification that passed the House in 2009 (before Tea Party control). It would have made reorganization easier for homeowners. The CBO analysis determined “over one million households would benefit financially,” though only around 350,000 would take advantage of it. But it said too little research existed to make macroeconomic predictions.
If a mortgage crisis dragged down the U.S. economy in 2008, and if it continues to slow any recovery, shouldn’t research focus on it?
In 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection” Act, which made it harder for consumers to file Chapter 7 and 13 bankruptcy. Like the Bush era tax cuts, BACPA now distorts the U.S. economy, a Gordian knot that needs untantangling. The 2009 house bill would have rolled-back certain BACPA provisions, but the bill died in the Senate after fierce mortgage industry lobbying. Then Republicans won the House, killed the legislation, and media no longer covers the issue.
We should be paying attention to what ameliorates America’s personal debt crisis. Can housing loans get modified to fluctuate according to macroeconomic conditions?
If one bought a house for half a million, and it’s now worth three hundred thousand, homeowners would like their mortgage payments to reduce accordingly, but banks would hate it. If ten years from now the house is worth a million, homeowners would hate to have their mortgage payments increased accordingly, but banks would love it. Although refinancing options might achieve some of this, it’s little help to distressed homeowners. But housing values and length of residency are proxies for macroeconomic conditions and life-span situations. If someone recently purchased a home (and they need it) they are most often in the upward swing of consumption and wage paths. If a recession causes house values to drop as well as their income, they face foreclosure. But as a young homeowner they will probably recover by the next business cycle, perhaps in five to seven years.
Reducing mortgage payments today, to reflect the lower house value, and increasing payments when house values rise, can be a sustainable solution for this homeowner. Their income stream should increase along with the house value. This is quite simplified, but suggests that taking a different view of the mortgage problem makes sense. Cramdowns were designed for dying companies, and the fact is, most companies fail. Most start-ups die in the first few years, but even survivors last ten or twelve years on average. Meanwhile homeowners are people, who typically last 80 or more, and if once employed, will be employed again if they’re only 40.
If the macroeconomy fluctuates more severely with time, mortgages should adapt. Furthermore, part of the increased volatility is due to the increase in credit.
We hear from moralists that personal credit is bad and its solution is to cut personal spending; a few realists explain that households need this debt to afford decent schools, neighborhoods, and social networks to climb in. While personal debt’s impact gets mentioned, it doesn’t receive macroeconomic focus it deserves. The politics around the new Consumer Protection Agency, for example, debated future consumer victimization vs. finance innovation. If consumer debt was a policy priority, debate would concern re-balancing consumer default penalties to better motivate lenders and borrowers to act in ways that promote macroeconomic stability.
Consumers with excess debt and/or repayment troubles could face a sequence of actions necessary to retain borrowing privileges. A continuum of borrower actions that must be met to avoid mounting penalties can replace the current regime. Today, borrowing soars until it hits a wall, and the resulting legal ramifications remove consumers from economic activity for years to come. Instead of this moralistic drain of demand and productivity, require borrowers who miss payments take online courses equivalent to what ticketed drivers must take to avoid license penalties. If the borrower doesn’t use the offered service, they incur a credit penalty.
Forbearance can suspend payments for several months without penalizing future credit availability, given certain conditions. A macroeconomic recession, unemployment above 9%, coinciding with an individual’s job loss, might qualify. Borrowers may have to submit a plan, using standard templates, showing a strategy to accomplish debt reduction, with benchmarks. These and other activity steps would help debtors maintain liquidity, as well as access future credit in good standing, as situations improve. For many, a standardized resource might help them strategize. At the same time, these actions would be backed by sanctions: failure to complete plans could trigger credit restrictions or rate hikes, sequencing towards more drastic measures.
The insurance industry handles auto policies with this pragmatic approach, and makes money. Lending institutions will likely resist such changes, because they cut the number of highly profitable customers they have, those with excess debt or repayment difficulties. Their credit score spikes, as their soaring APRs multiplies large balances, to profit banks in the short-term. But this depresses consumer demand now and into the future, and causes the debtor to have more debt each billing cycle. As debtors fall, they face asset seizures, leading to capital loss that can extend to the next generation. Some will argue that banks are too fragile to support auto insurance standards, and that moral hazards will be promoted by debt easing. Let the public consider trade-offs.
Bank debt is interconnected horizontally across varied business sectors, vertically between different sized financial institutions, globally extending to foreign governments and market instruments, yet bank revenue still depends on retail capacities. Since the financial crisis, bankers fear credit complexity exposes them to multiple, hard-to-determine risks, so they hoard money despite their business model as lenders.
Financial institutions depend on high-interest consumer borrowers as a profit pipeline, more than they worry about consumer default. Government laws protect lenders, by preventing borrowers from defaulting because of bankruptcy or even death. This hedge’s banks default risk, so that enforcement costs like asset seizure are more important bank calculations. Market principles suggest bankers should balance higher interest rates against the increased default risk they engender, because they can’t visit borrowers like money lenders to enforce repayment. But the government has become the lenders’ enforcer. While banks pay close attention to creditor’s payment history, legal default is extremely difficult for borrowers to obtain.
If wise policy addresses priority problems first, consumer debt should be its focus. The most basic factor is wages, which deserve much more public attention than they now receive. Consumers borrow to supplement insufficient incomes. Stagnant wages in America correlate closely with the growth of personal debt. While I believe this resonates with the public, today’s political communication offers no foothold for wage analysis (except for extremes, CEO fortunes and the minimum wage). Changing consumer culture seems even more unlikely. Instead, the policy debate could, and should, deal with changing repayment laws and examining debt forbearance (where borrowers can skip certain payments because of hardship, without losing credit). Consumer debt solutions involve trade-offs, but banker anxiety should not be a veto to discussion.
A quick word about taxes. If perceived value from tax-based government spending is higher than their opportunity cost (the value of consumption or investment tax payers might prefer), then many citizens will support those tax rates. This is an asymmetric question, of course, because while individuals easily access their own consumption and investment data, they depend on media to provide evidence of government spending value.
Determining value is subjective; one man’s yacht is another’s wasteful spending. A parent knows their child’s private school tuition benefits his future productivity, but what about the three children who could advance to college with extra public school funding, including his own? One family’s credit card debt sorely constrains their potential entrepreneurship, another family’s credit cards enable them to bootstrap a small business. Do 25% interest payments benefit society more than the reduced credit access an APR ceiling would provoke? Americans avoid difficult, subjective, but important discussion, if they think their consumption and investment is economically superior to government spending. This nonsense is peddled by the hard right-wing, and is an excuse for uninspired media reporting.
Corporations should also be in media focus. Companies continue to earn revenue and put aside profit, while banks hedge against their strategies, both short and long-term.
The banks have good reason to worry. Firms usually have an array of possible asset purchases that carry little interest charge. These are investments only dynamic firms with unique vision can exploit. Because of strategic expertise, a company prefers to spend its own capital, its retained earnings, on its special knowledge. Companies get financing for operating and functional expenses, perhaps more easily than more visionary investments; rolling a large overhead isn’t a problem under good management.
The growth of retained earnings among US companies concerns banks, and should concern the public. Few would deny this cash needs circulation; but companies and banks question how to do so profitably. Firms claim they lack certainty; a vague excuse. More likely, they lack vision. They don’t know what special investments will lead to growth. This is nothing new; only select companies consistently have extraordinary vision. But usually retained earnings don’t swell so many balance sheets; most companies do better distributing dividends and increasing equity values.
But today’s dividends and share repurchases haven’t diminished cash hoards; further, company deleveraging increases cash retention. When a nation, a company, or a family cuts spending, they save more. Supply side theory predicts these savings inevitably get invested and lead to growth. While logical, this is insufficient to explain business facts. Investment depends on expected future revenue, because returns depend on it. So demand, expected and real, is necessary for investment.
Corporations have lots of cash; they should be investing in future products, services, networks, human capital, in ways their expertise and insight can find competitive advantage. But that’s not happening, at least among most. These actions speak louder than words: companies don’t know what local and global consumers, other businesses, and governments will want in the future.
This contradicts supply-side reasons to cut government spending. Fiscal savings aren’t needed for investment; the problem lies with future demand. Green energy is a case in point. Regulations change each new legislature, along with government investments. Citizens lack the knowledge to predict energy costs from new and old sources. Although new technology requires ten-year planning horizons, investors are reduced to short-term goals. They can’t predict future demand, partly from regulation churn and consumer indecision, and partly because the best technology waits for development.
A trillion cuts won’t solve this dilemma, because it isn’t limited by investors who lack money. America will grow a new energy sector with government initially in the lead, dispersing basic R&D investment in many categories, expecting many dead-ends, but also a few winners. Investors will waste no time seizing winning ideas, once developed sufficiently, but today most lack the vision to predict winners — I certainly lack it. Investors also need stable regulations, and consumers with moderate government subsidies, to offset older resources with fixed cost advantages.
If the problem is a lack of vision, not a lack of capital, spending cuts do more harm than good. Government spends in areas that lead to new investment visions — basic research, education, DARPA — and cutting these outlays will reduce future product supply and future consumer demand. The 1950s and 1960s economies built hugely on government investments in aerospace, initially triggered by World War II. The 1990s productivity boom was partly driven by government’s funding of computer and biotech research and infrastructure projects in the 1960s and 1970s, notably in the military-university complex. This back-door government investment is often in non-government scientists and businesses; a piper who plays second-fiddle gets ignored in some history, but without him there’s no start-up music.
Also important, government outlays pull investment into new areas, through effective demand. The entitlements everyone criticizes can pull growth. Medicare finances most health care innovation, along with veterans programs. Health care is certainly one of today’s most important investment arenas, so cutting demand is not obviously a good idea. Yet that’s what today’s elected politicians call for.
The public will find its bearings, presumably, but not while the media converges on today’s fashionable story-line, government debt and unemployment. No one dares say that unemployment may not be the biggest demand problem. Few suggest that government deficit doesn’t require slashing the federal budget, even though letting the Bush tax cuts lapse would reduce the decade’s deficit by an adequate four trillion dollars. As Lincoln said, these things would be like a man wearing his wife’s hat to church. No one gets hurt, but no reputable man volunteers.