Wednesday, September 8, 2010

What a Mess

Dhaval Joshi awhile back discussed the $4 trillion dollar mortgage problem:
Can the US economy really return to “business as usual” when it has 4 million houses surplus to requirement, when 1 out of 4 mortgages are in negative equity, and when by our calculation, it is burdened with $4 trillion of excess mortgage debt, equivalent to 30% of GDP?

For many years, total mortgage debt consistently and reliably equalled 0.4 times the value of the US housing stock. Intuitively, this average of 0.4 makes perfect sense as every property usually has a mortgage ranging from 0 to 0.9 times its value. So in 1990, $6 trillion of housing collateral could support $2.5 trillion of mortgages, and by 2006, $23 trillion of housing collateral could support $10 trillion of mortgages. But since then, the US housing stock’s value has slumped to $16 trillion which means the amount of mortgage lending supportable by the collateral has plunged to $6 trillion. However, actual mortgage debt has remained at $10 trillion – $4 trillion too high.

The fact that mortgage debt has barely declined suggests that relatively few homeowners have defaulted on their mortgages or paid off debt yet. Instead, a quarter of all borrowers are sitting on negative equity. That’s just as well – because were mortgage debt to shrink by even half of $4 trillion, the US economy would slump.
Here is the accompanying figure:

[Update: the greenish line in the top panel should be labeled "U.S. residential real-estate assets multiplied by 0.4." The 0.4 represents the how much mortgage debt has been as a percent of the U.S. housing stock historically.  Joshi considers it the sustainable level of mortgage debt given the collateral value of housing. I added the second paragraphs above to make this clearer.]
I was reminded of Joshi's article after reading this by Tyler Cowen:
It seems increasingly clear that we must [let house prices fall].  For how long can the government prop them up?  Are we never to have a private market in mortgages again?

Yet what happens if we let them fall?  Arguably many banks would once again be "under water."  Enthusiasm for another set of bailouts is weak, to say the least.  Our government would end up nationalizing these banks and it still would be on the hook for their debts.  The blow to confidence would be a major one, especially if along the way we saw a recreation of a Lehman or Bear Stearns or A.I.G. episode.

I increasingly believe there is no easy way out of this dilemma and it is a major reason why the U.S. economy remains stuck.  Housing prices must fall, yet...housing prices must not fall.
What a mess we are in.  So what can be done? My recommendation is (1) have the Fed take more aggressive actions to stabilize the macroeconomy which would make it easier to (2) do the structural changes needed to address the problems outlined above.  One specific structural proposal would be to swap underwater mortgage debt for equity. What suggestions do you have?


  1. first of all, you've underestimated the problem...there are nearly 19 million vacant houses; you gave the number on the market...see:

    the median starting wage is going down...about 76% of the job growth this year has been in jobs that paid below $15 an hour...with the median home price still north of $190,000, there wont be many of these newly re-employed being able to afford homes at those prices...

    so sooner or later, prices are going to have to return to their historical relationship:

    the only way house prices can this remain high would be if they were subsidized or the minimum wage were raised...

  2. The way out is microeconomic stimulus - otherwise known as deregulation. Increased tax revenues, increased investment, increased consumer spending, lower inflation, job creation, higher returns for savers, improved education, improved health care, energy independence, etc.,etc., etc.

  3. David, The graph is incorrect, it suggests mortgage debt exceeds house assets, while the reverse is actually true. If I were you I'd delete that graph, or provide some sort of explanation. The bottom graph seems OK.

  4. I think reflating property markets is Job One, and generating mild inflation.

    This will recharge the economy, and bolster both lenders (who may not get paid back without relfation) and borrowers (who will find debts shrinking relative to assets and income).

    There are structral improvements in the economy we could make, such as paring back the vast federal rural infrastructure-farm welfare archipelago, or cutting military outlays in half, but that is politics.

    QE hard and heavy is what we need.

  5. btw, it wouldnt just be the banks that get hit:

    FDIC's Bair Warns of Government "Exposure" in Mortgages(Reuters) - A key U.S. banking regulator raised concern on Wednesday about the risk of "exposure" the government is taking on in the mortgage market and urged more stringent standards for underwriting mortgages. "We should all be concerned about the type of exposure that the government is taking on through guaranteeing so many mortgages right now and make sure that we do have some prudent underwriting standards," Federal Deposit Insurance Corp Chairman Sheila Bair suggested in an interview on CNBC. "The government is taking on a lot of exposure and guaranteeing most mortgages that are being originated these days," she said. "And I think the policymakers here are trying to balance the need for prudent underwriting with a need to support... what is still a very distressed housing market." Mortgage finance giants Fannie Mae and Freddie Mac, under government control since September 2008, and the Federal Housing Administration, currently back some 90 percent of new U.S. mortgages.

  6. Scott:

    The graph is correct, the label is wrong. It should read "real estate value x 0.4." The 0.4 represents the how much mortgage debt has been as a percent of the U.S. housing stock historically. Joshi considers it the sustainable level of mortgage debt given the collateral value of housing. I added the second paragraphs above to make this clearer.

  7. Strange bedfellows.

    Obviously, Ronald Reagan (because of his tax cuts).

    Clinton may have run budget surpluses, but the trade deficit cratered during his terms.

    The private-sector is deleveraging & the public-sector will eventually have to too.

    One cool thing, the FED flattened the yield curve (by buying longer dated Treasuries), and saved a bundle on the interest expense item in the Federal Budget.

    The BOG can't forecast short-term. A Black Monday is directly ahead - although this time gDp will contract in concert (during the 4th qtr).

    Countervailing intervention is a no brainer. But it will drive the dollar's exchange value lower, & prices higher. The "trading desk" will undershoot, then overshoot. Congress will finally act.

  8. The obvious solution is to raise interest rates AND liquidate - but only allow private investors to acquire the homes in $1 auctions with 40% down.

    The current issue we face is this:

    800+ insolvent banks
    The remaining banks are sitting on their assets BECAUSE they hope to acquire the assets of the failed banks in FDIC take downs (loss sharing).

    The remaining banks need to forget this, instead let the FDIC go broke in liquidation auctions... backed up by Treasury.

    See this as QE, effectively putting the 6-10M hard assets (the houses) onto the balance sheets of the guys with dry powder - meanwhile the remaining banks IMMEDIATELY have millions of SAFE loans to write:

    1. priced below market value
    2. good credit borrowers
    3. 40% down
    4. higher interest rates