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Nov 1, 2012
20 Min read time
Debt relief is fair. It would also be good for the economy. Why isn’t it happening? Politics.
The Great Recession officially ended in June 2009. But after more than three years of “recovery,” economic growth remains sluggish and more than 12 million people are still out of work.
The conventional explanation for this slow-motion recovery is presented with great clarity in Carmen Reinhart and Kenneth Rogoff’s This Time Is Different (2009). The basic story, as the ironic title suggests, is that financial crises are always followed by slow recoveries: this time is no different at all. No surprise, then, that so much economic pain remains, that a Great Moderation has followed the Great Recession. This analysis suggests that the country should not focus on the immediate problem of mass unemployment, about which little can be done. Instead we should turn attention to long-term issues, such as tax reform and education.
Another theory, less passive in its policy implications, is that we are living through a “balance-sheet recession.” Popularized by Richard Koo and Paul Krugman, this view traces the sluggish recovery to the collapse of the housing bubble. The root of our continuing economic troubles is not that cautious creditors remain uneasy about lending but that debtors have cut their consumption because of the housing bust and its aftermath. Too many people are trying to save at the same time, reducing our economic potential.
If the balance-sheet argument is right, then the fundamental problem is households facing bad debts. Helping them deal with this debt hangover is essential to escaping our low-growth/high-unemployment trap.
But help has not arrived, and the reasons lie in three decades of legal developments, organizational shifts in the financial sector, and changing ideas and attitudes. The rights of creditors have gained legal and political prominence. And debt relief is rarely perceived as a fair way to deal with especially heavy burdens, or as an effective policy for rekindling growth. It is commonly condemned as rewarding irresponsible past behavior and encouraging more of the same in the future. Because of these changes, mortgage relief—or any other kind of debt relief—is very hard to achieve. How has this happened, and what can we do about it?
• • •
The balance-sheet theory of the recession begins from the idea that households try to keep a manageable amount of debt. They judge what is manageable by considering both sides of the ledger: the value of their assets and the debts on those assets. If the value of their assets collapses, they try to pay down debt in order to restore their household balance sheets.
In the housing bubble prior to the economic crisis, households took on significant amounts of mortgage debt. But homeowners judged the debt to be manageable because it was balanced by double-digit growth in housing values. Those housing values started to crash in 2006. Households then began to pull back on their consumption in order to pay down debts and restore their balance sheets.
This “deleveraging” process is a healthy thing for an individual household. The problem comes when everyone does it. If everyone is saving at once, overall consumer spending falls. This creates even more idle resources: prices fall and unemployment increases, which leads people to save even more as their worries about the economy and housing deepen. The result is a downward spiral, with even greater deleveraging and greater unemployment.
The Federal Reserve has tried to break the current cycle by lowering interest rates. People do not want to park their money in accounts that deliver very low returns, so, theoretically, reduced interest rates encourage people to spend more. Increased spending by people who are not worried about their balance sheets should help to correct for the decline in consumption by people who are deleveraging.
But this policy has limits. Interest rates have a “zero lower bound.” Practically speaking, they can’t go negative. And because there was so much deleveraging after the housing bubble burst, interest rates would need to have gone negative right at the beginning of the recession in order to encourage the spending needed to keep the economy near full employment. With the interest rate languishing at the zero lower bound, conventional monetary policy has been exhausted and the economy has gone (and stayed) haywire.
Several years into the crisis, empirical research strongly backs this view of the recession. Economists Atif Mian and Amir Sufi have explored the relationship of debt to economic performance at the county level and found that counties that came into the recession with high leverage now have lower consumption, higher unemployment, and especially sluggish wage growth. The problem, according to Mian and Sufi, is not that people who lost a lot of housing value are consuming less because their wealth declined. Instead their reduced consumption is driven by the debt on the other side of the balance sheet. They consume less because the ratio of debt to assets has become unmanageable.
During the Great Depression, the federal government allocated 8 percent of GNP to repairing failing mortgages.
Karen Dynan, another economist, replicated these results on the basis of household survey data. She found that highly leveraged homeowners had significantly larger declines in spending than did less leveraged homeowners whose properties may have suffered comparable declines in value. She also noted that households, as a whole, have made limited progress in getting leverage down.
And the International Monetary Fund has done similar research internationally. It turns out that housing busts in major economies over the past 30 years had significantly worse implications for growth and employment when there were higher levels of debt going into the bust. The IMF found that this happens with or without financial crises, implying that Reinhart and Rogoff’s thesis isn’t important, and perhaps is even backwards.
So we appear to be muddling through a balance-sheet recession. With large-scale deleveraging putting significant strain on efforts at economic stabilization, debt relief would help. Why isn’t it happening?
• • •
One reason is that our bankruptcy laws have become more punitive.
In 2009 Senator Richard Durbin declared that the largest financial institutions, thanks to their lobbyists on Capitol Hill, “frankly own the place.” He was responding to the failure of Congress to change bankruptcy laws to allow for “lien stripping,” sometimes referred to in the popular press as “cramdown.” Lien stripping would let bankruptcy judges reduce mortgage liabilities for homeowners filing for bankruptcy—a useful intervention in a balance-sheet recession. Currently, bankruptcy judges can do this for second homes, but not for primary homes, which constitute the bulk of ordinary Americans’ investments and wealth.
Allowing lien stripping on primary residences would not be a historical anomaly. More lenient bankruptcy legislation has followed deep economic crises before. The federal Bankruptcy Act of 1841 for instance, was passed in reaction to the financial crisis of 1837 and the recession that followed it. Under the 1841 Act, debtors could be discharged of their debts without the consent of creditors. Over the course of thirteen months, some 44,000 people took advantage of the new opportunity. The act was rescinded once the economy rebounded.
Our history provides other examples of policies that have ameliorated household balance shortfalls, too. During the Great Depression, President Franklin Roosevelt instituted the Homeowners Loan Corporation (HOLC), which purchased significant amounts of failing mortgages, renegotiated them, and made a slight profit. The program cost roughly $3.28 billion at the time, which was 5 percent of gross national product. Even more—8 percent of GNP—was allocated, ready to go if needed. Imagine if the federal government allocated 8 percent of GNP to the same problem today. That would be about a trillion dollars.
What is different this time is the politics. Efforts to counter the housing crisis have come under political attack. For instance, the Tea Party was born from TV pundit Rick Santelli’s criticism of the Home Affordable Modification Program (HAMP). Considered weak by many housing activists when it was announced, HAMP was too much by conservative standards. Santellli asked people on the floor of the Chicago Mercantile Exchange if they wanted to bail out their neighbors’ mortgages, and they responded with boos.
Neil Barofsky, the former special inspector general for the Troubled Asset Relief Program and author of the new book Bailout, has argued that the Obama White House was terrified of being accused of helping “undeserving homeowners.” Better to help banks deal with the consequences of waves of foreclosures by spreading them out than to tackle the foreclosures directly. Congressional Democrats told reporters atProPublica that former National Economic Council Director Lawrence Summers dismissed the idea of addressing the mortgage crisis through the bankruptcy courts, and Treasury Secretary Timothy Geithner pushed back against efforts by congressional Democrats to recreate a HOLC-like mechanism or to deal with the housing crisis by creatively using powers such as eminent domain.
The Summers-Geithner position went against Obama’s campaign promises and against the administration’s promises to liberals in Congress. When the second round of bailout money was up for a vote, many progressive senators were worried that not enough was being done to help homeowners. To win their support, Summers wrote a letter on behalf of the administration vowing full effort in “reforming our bankruptcy laws.”
The debt collection process has become more vicious, leading to 21st century debtors’ prison.
When the stock market bubble collapsed in the early 2000s, the allocation of most losses was settled within months. Even the most dragged-out bankruptcies were over in less than two years. However, when it comes to consumers’ bad debts, the story is different. Six years after the housing bubble burst, there is still no clear sense of how losses will be allocated. The only certainty is that they will hang over the economy and households into the foreseeable future.
This unwillingness to assist consumer debtors is the culmination of a series of creditor-friendly legal and institutional shifts. Specifically, Since the early 1980s, three important changes have brought exploding consumer debt burdens.
The first is the extraordinary expansion in the scale and scope of the financial industry and the deregulation of its relationship with consumers. In 1960 finance and insurance accounted for 4 percent of GDP, but by 2009 it had doubled to 8 percent. In 1978 the Supreme Court unanimously overturned the application of state-level usury laws to nationally chartered banks, removing one of the frontline regulations of consumer credit. Whereas banks and financial institutions previously were subject to different regulations in each state they operated in, the Court’s decision meant they would instead be regulated only by the state they were incorporated in. So the banks moved to states with friendly regulations, leading to volatile interest rates and plenty of fine print for customers, no matter where they lived.
The second driver of debt is a monetary policy less concerned with full employment and more concerned with inflation. Beginning with Fed actions under Paul Volcker in the early 1980s, this policy has lead to relatively high interest rates. High rates increase the value of financial assets and bolster the wealth of creditors, but they also increase the relative debt burden for households.
The third issue is the increasing volatility and instability of family income. While earnings have fluctuated, the prices of core goods that define middle-class stability—including health care, housing, and education—have risen dramatically as risks and costs have shifted from the government and employers onto individuals.
With credit easing and costs rising, borrowing seemed like a safety net. As a result consumer bankruptcies began to skyrocket in the 1980s. While many assume that the increase reflects extravagant consumerism, research shows that most families entering bankruptcy have been hit by unexpected misfortune and the growing costs of basic goods.
Because of this explosion in consumer credit, the financial industry, lead by the credit card companies, worked hard to ensure that it would be able to collect. Lenders aimed to amend the bankruptcy code to make it significantly harder for families to “discharge” debt—to have the debt forgiven in a bankruptcy proceeding. The first bill, put forward by industry-friendly legislators in the late 1990s, was stalled due to the influence of Hillary Clinton, who criticized its lack of protection for women and children. A second attempt in 2002 floundered when conservatives objected to a provision that would have made liabilities incurred while protesting abortion clinics non-dischargeable. Finally, in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was passed, erecting new barriers to forgiveness, including forgiveness of private student loan debts, which now are no longer dischargeable in bankruptcy.
Alongside these changes, the debt collection industry has grown rapidly. According to Federal Reserve data, debt collection agencies collected from just 7 percent of consumers in 2000. Today that figure has doubled.
The debt collection process has also become more vicious. “In personam” debt collection, previously limited to “extraordinary” situations, has become the new normal. These actions, according to legal scholar Lea Shepherd, “are often initiated and executed on a high-volume basis and with a striking degree of informality.” These techniques are enforced through the courts’ authority to hold debtors in contempt, which means that not following through results in imprisonment. Debt collectors are also intimidating debtors by writing collection notices on district attorney letterheads, further blurring the line between the law and debt collection.
The result, according to some critics, is 21st-century debtors’ prison. Disturbingly, bail posted for these contempt charges is often used to pay creditors. As bankruptcy law expert Alan White describes it, “If, in effect, people are being incarcerated until they pay bail, and bail is being used to pay their debts, then they’re being incarcerated to pay their debts.” The Federal Trade Commission points out that debtors being jailed for nonappearance “may be willing to pay the bail (and indirectly the judgment) using assets (such as Social Security payments) the law prohibits creditors from garnishing or otherwise obtaining to satisfy a judgment.”
Individuals don’t create all the conditions that undermine them.
The possibility that debtors are “willing” to be jailed to make an end run around prohibited payments underscores how desperate some households are. To gain a sense of the implications of these changes in consumer bankruptcy law in the past decade, consider recent research finding that households are more likely to file for bankruptcy after they receive tax rebates. The reason is that between 30,000 and 60,000 households going under don’t have the funds required to file.
The new rules were designed to be stringent. Legal scholar Ronald Mann calls the results of recent bankruptcy reform a “sweat box.” The purpose of the reforms is not to reduce the number of bankruptcies or even to increase creditors’ recovery. Instead it is to sweat people with massive debts by drawing out the payment period before they can seek legal help. Many of the features of BAPCA, from raising filing fees to requiring credit counseling, are designed to lengthen the period of distress before relief can be obtained in court. During this time the debtor is paying more and more to stay current.
• • •
Lew Ranieri, the creator of the mortgage-backed security, sounded a major alarm going into the financial crisis. He noted that bondholders
are almost always better off restructuring a loan in a crisis with a borrower than going to a foreclosure. . . . If we keep letting these things go into foreclosure it’s a feedback loop where it will ultimately crush the consumer economy.
But he simultaneously warned that the system was not designed to handle massive loan restructuring. That’s because the mortgage servicers that run the mortgage backed–security industry have little incentive to make sound modifications to mortgages. Doing so requires significant labor and expertise, including the skill to make new loans. Given how hard restructuring can be, servicers prefer to speed through foreclosures and to ignore modifications that might work. Servicers are also paid in a way that encourages bad modifications that will eventually default anew.
Laziness of this sort doesn’t hurt servicers’ bottom lines, but it does create losses for investors and communities. The Urban Institute finds that for each property in foreclosure abandoned before the process is complete, the local government can be on the hook for around $20,000 from lost property taxes, the cost of serving notices to secure property, and other burdens it is forced to absorb. Studies by housing researchers Dan Immergluck and Geoff Smith and again by the Urban Institute also show that mass foreclosures contribute to higher rates of violent crime. And a Government Accountability Office report finds that with enough foreclosures, neighborhoods fall into long-term decline.
Beyond the cost to neighborhoods, mass foreclosures pose a serious macroeconomic problem thanks to fire sales. Foreclosed homes sell at major losses, if they sell at all. And an increase in vacant and foreclosed homes reduces the value of neighboring homes. This destroys their balance sheets, which makes them reduce consumption even further, keeping the downward spiral in motion. Meanwhile municipalities have less revenue coming in and more costs in upkeep. The increasing number of renters causes rental prices to skyrocket.
The sweat-box model of handling debt isn’t confined to credit cards and mortgages. It is also a major factor in student loans. Recoveries on student loans are high because student-loan debtors have virtually no bankruptcy protections. So it is profitable to sweat them over and over again. As with mortgage debt, restructuring student loans is hard work. It also can lead to lower gains for debt collectors.
Our systems of issuing and recovering loans have therefore evolved in ways that keep people perpetually in unstable debts, prone to collapse. The goal of collection is no longer the quick and reasonable recouping of debts, but rather to drag out payments.
• • •
In response to the growing challenges facing debtors, there have been some efforts to organize them politically. The Occupy movement, for instance, created campaigns surrounding student debt and foreclosure prevention.
But this is a difficult proposition. People do not like their identities being bound up with debt, especially debt they cannot handle. To be sure, the movements focus on identifying the positive values associated with each case, but organizers often have difficulty overcoming the stigma associated with indebtedness, a stigma derived from the idea that debt is a result of bad choices for which we must hold individuals personally responsible.
But when it comes to debt, this hyper-individualism is a poor guide for both morality and policy.
Consumer debt is not simply a matter of personal choice. It operates within a complex system of rules and institutions. Medical debt is a result of choices we have made together about how the health care market is organized. Student loan debt is a function of the accessibility of higher education. Credit card debt is situated within a broader system of compensation and income support. Mortgage debt in part reflects national tax policy on mortgage interest deductions.
Dealing fairly when things have gone bad is the purpose of the bankruptcy code.
Nor is debt itself a bad thing. Borrowing—for education, health, housing—can be an engine for mobility and investment. But who benefits from debt depends, once more, on our policies and institutions. Consider student loans. Taking on debt in order to attend a high-quality public university is a significantly better investment than attending a for-profit institution. A good public policy might then restrict government funding to supporting education at public institutions. However, rather than reserving public support to students at public schools, which would also broaden access by creating a larger pot of financial-aid money, the government allows students to use public money to finance for-profit education. This is a stark example of how policy affects who benefits from debt and how useful leveraged investments can be for debtors.
If the effects of debt are determined by public laws and policies, not just by individual choices, how should we think about the public side of the issue? What issues of justice are at stake?
Considerable intellectual energy has been devoted to understanding what is a just society—in John Rawls’s phrase, a “fair system of social cooperation.” And much of this energy has focused on how to distribute the fruits of cooperation when things are going reasonably well, how to determine who is entitled to benefit from a strong economy and in what ways.
Much less attention is paid to what we ought to do when things go badly. Just as we “didn’t build” all of the pieces that factor into our successes, individuals don’t create all the conditions that undermine their success. Recessions wipe out even businesses run by hard-working people making great products. Medical debts can overwhelm people through no fault of their own. Mortgages go underwater because neighborhood prices drop or as a result of a financial sector–induced housing bubble, not simply because of unwise personal decisions.
Dealing fairly when things have gone bad is the purpose of the bankruptcy code. Our laws, institutions, and policies create the conditions under which people take risks, shape the ways that we distribute gains and losses, and help to define how we think about who deserves what. Until recently, however, there has been little understanding about what would constitute a fair bankruptcy code.
One idea—the “creditors’ bargain,” developed by Thomas Jackson in a 1982 Yale Law Journal article—focuses entirely on creditors. Imagine bankruptcy law as a system of rules that creditors would agree to if they could bargain among themselves ex ante, before having made any loans. If creditors didn’t know what kind of loans they would make, how would they create a legal system solely to benefit themselves? Bankruptcy law prevents some creditors trying to jump ahead of others or free riding off the debt forgiveness of other creditors. It’s a way of binding collective action among many different creditors.
But this exclusive focus on creditors is too narrow to create a fair system, and it has some troublesome implications. In a sense the creditors’ bargain produces a completely private system of bankruptcy law in which it is impossible to modify contracts. The mortgage-backed securities driving mass foreclosure are an experiment in this theory. As we have seen, it is very difficult for the servicers who run the system to modify loans, even when modifications would produce better results. This leads to “suicide pact” contracts where parties lock themselves into a course of action even if it means a lot of value is destroyed in the long term. The sweat-box model also evolves from the idea, implicit in the creditors’ bargain, that the only institutional concern is protecting creditors’ recoveries.
Others have presented a more expansive picture of the relevant values and players. As Elizabeth Warren notes, “Bankruptcy encompasses a number of competing—and sometimes conflicting—values.” For example, communities take a large hit from foreclosures, and thus have an interest in mitigating them, even though they aren’t a traditional party to the transaction. Rather than a legal system designed to organize the behavior of creditors, bankruptcy law can keep additional stakeholders, such as communities, in the picture. The law might also emphasize preservation of value and fair distribution.
• • •
Indeed, debt as a whole is a matter of public concern: it is about the health of our economy. Individual debts, added up, affect all of us. Bad mortgage debts hold back our economy from producing all it can. Student debts can prevent household formation, which puts a drag on the housing market.
Society has always evolved mechanisms for dealing with mass debts, especially when those debts are partly the product of other social institutions. Today’s institutions and laws surrounding bankruptcy reflect evolution in a more creditor-friendly direction, even as bankruptcy has been functioning ever more as part of the social safety net, filling in for the lack of comprehensive medical coverage and basic income maintenance in the United States. This shift should be resisted.
In our society, two ideals struggle for preeminence. One uses the contract between independent individuals as the metaphor for all social and political relationships. According to this ideal, bankruptcy is what happens when a contract goes bad. The second ideal is about establishing a system of social cooperation in which individuals make personal decisions under fair conditions. According to this ideal, bankruptcy is about what we have done in our laws and policies as well as the choices that individuals have made. Providing debt relief, then, is not about making excuses for irresponsible individuals, about extricating them from the obligations that flow from their contracts. Instead, it may be called for both to reestablish economic prosperity and to make our institutions fairer for everyone.
November 01, 2012
20 Min read time