Institute for Financial Transparency

Shining a light on the opaque corners of finance


Playbook for housing related financial crisis response

Kevin Carmichael wrote a terrific article in which he makes the case for the Canadian government bailing out borrowers when its current housing bubble pops and a financial crisis ensues.

In Transparency Games, I refer to his proposed response as the Swedish Model.  The focus of the response is using the financial system to save the real economy.  As shown by the US in the 1930s, Sweden in the 1990s and Iceland in 2008/2009, this response always works to end a financial crisis quickly and with minimal damage to the real economy.  The alternative response is the Japanese Model.  The focus of this response is on saving the banking system.  As shown by Japan, the EU, UK and US, this response never ends a financial crisis and always maximizes the damage to the real economy.

Mr. Carmichael based his article on the work done by Atif Mian of Princeton and Amir Sufi of the University of Chicago.  Their work supports adoption of the Swedish Model playbook for responding to a financial crisis by making the case for bailing out borrowers.

Mr. Carmichael begins to make the argument for adopting the Swedish Model by observing:

And that brings us back to those suffering new homeowners in Vancouver and Toronto.

If things go bad, they will deserve a lot of the blame. Governments, the central bank, and lenders tempted them with numerous incentives to buy, but no one forced them to take out mortgages they couldn’t afford.

This statement is fundamentally wrong.

It is not the borrower’s responsibility to avoid taking on more debt than they can afford.  It is always the lender’s responsibility to not lend more than the borrower can reasonably afford.

There is a reason lenders ask to see how much the borrower earns and has in savings.  The reason is lenders are suppose to absorb any losses from the failure of the borrower to repay the loan.  Lenders ask for this information so they can do their homework and limit the amount of credit they extend to what the borrower can afford to pay.

But what if I told you the only way to end the recession they might trigger would be to use your tax contributions to bail them out? Don’t like the sound of rescuing your profligate neighbours? Sorry, a crisis is no time for schadenfreude.

In the US, the Tea Party owes its existence to the anger over the idea the profligate neighbor was getting a benefit by being bailed out.

David Dodge, the former Bank of Canada governor, told me earlier this year … it always will be taxpayers who clean up the messes of bankers, especially when it involves houses. “History tells us, and political analysis tells us, that no government can stand aside while the financial market is being brought down by the collapse of the mortgage market,” he said.

Ottawa’s instinct likely would be to save the banks. That’s just how these things go. The received wisdom is that you fix a financial crisis by making sure the lenders are solvent. That way, they can keep the economy going by lending to businesses and households.

The received wisdom on how to fix a financial crisis is wrong.

In fact, banks are designed to absorb the losses on the bad debt they hold.  They were designed this way so they could be used to protect the real economy and make the loans needed to keep the economy going.

I explained this in detail in Transparency Games, but the short version is due to deposit insurance, taxpayers are the banks silent equity partners when the banks are insolvent.  As a result, banks can take the accounting losses for the bad debt and still be in a position of making new loans.

Mr. Carmichael goes on:

Mian and Sufi want policy makers to update their crisis playbooks. The banks got most of the money when the U.S. financial system imploded in 2008 and it didn’t work that well. The biggest banks survived, but they stashed most of their rescue funds. The Great Recession was followed by an epically slow recovery.

In retrospect, the flaw in the U.S. rescue efforts is obvious. In their 2014 book House of Debt, Mian and Sufi argue the recession was caused by a decline in consumer spending. … The poorest households were wiped out first. As home prices crashed, many were left with assets worth less than the mortgages. That was critical because those are the people who have the highest propensity to spend.

If those ruined households would have received as much attention as Wall Street, the world would be a different place today.

The flaw in the U.S. rescue efforts wasn’t just obvious in retrospect.  I said bailing out the big banks and pursuing aggressive monetary policies like ZIRP/QE wouldn’t fix the underlying problems with the real economy.

The observation the world would be a different place today if those ruined households had received as much attention as Wall Street confirms I was right.

Washington’s priority should have been organizing a mass rewriting of home loans to align the principals with the reduced value of the assets. That would have supported demand by allowing homeowners to get above water. By reducing the number of defaults, such a program also would have buoyed housing prices.

Iceland showed how to handle the problem of mass rewriting of home loans and not trigger the anger that gave rise to the Tea Party.  It wrote down mortgage debt to the greater of what the borrower could afford or a third party would pay for the collateral (house or condo).  The goal wasn’t to get the borrower “above water”.  Instead, the borrower didn’t gain any equity in the house.  In fact, any down payment they had previously made was lost.  As a result, there was no reason for anger.  This way of addressing the unaffordable mortgage debt was seen as fair to the borrower and their neighbors.

When the home loans were rewritten, the Icelandic banks had to absorb the loss between the original mortgages and the new mortgages.  As a result, the banks and their shareholders were held responsible for the bankers’ failure to restrain their lending to what the borrowers could afford.

When I have said the U.S. could have done something similar, I received pushback that this wasn’t possible because the loans had been packaged into a security (of course, not all mortgage loans were packaged into a security, but the objectors didn’t want to hear that).  However, since the price of these securities plummeted at the start of the financial crisis, there was no reason the U.S. couldn’t have passed a law requiring the underlying mortgages be written down (had it done so, the securities might actually have gone up in price).  Instead, the Obama Administration pursued policies to foam the runway for the banks and allow them to extract as much value as they could for themselves from administering these securities.  This resulted in foreclosures that could and more importantly should have been avoided.