The biggest challenges facing the American economy (and the global economy) are unsustainable debt levels and a lack of job creation. These two go hand in hand, as without job creation debt cannot be serviced adequately, and with the burden of excess debt consumers are unable to increase spending. The good news is progress is being made, as consumers are slowly digging their way out of their financial morase. The bad news is the hole is very deep, and it will take a long time to earn and save our way out of the problem. Policy makers are struggling with ways to assist distressed consumers, but their efforts are not without problem both in terms of implementation and the moral implication of continued bailout.
Much has been written about the conundrum facing policy makers concerning the economy. On one side we have the Keynesians suggesting the economic expansion is not self sustaining, and further stimulus needs to be injected into the market to boost consumer spending. On the other side, are the fiscal conservatives who note the overwhelming debt burden at all levels and preach fiscal austerity. Recently, the New York Fed published an analysis of consumer finances that while containing some good news, is certainly sobering. In their report the NY Fed states that progress has been made in paying down debt by consumers. The reduction has been $812 billion, or about 6.5% from the peak in Q3 2008. Obviously, debt reductions are a positive sign in moving toward a healthy economy. But, looking at the above chart one has to wonder if these are really consumers we want to incent to spend more. As noted by the Fed report household delinquency has stabilized somewhat, albeit at extremely stressed levels. As of June 30, 11.4% of outstanding debt was in some stage of delinquency, an improvement from March readings of 11.9%. However, looking at the chart below give one a better perspective of the scope of the problem and the extent to which stabilization is a long way from solution.
Throughout the first half of the past decade, delinquencies ran at approximately 5% of all loans. Now we are twice that level. This should surprise no one, as unemployment levels are similarly twice that of previous averages.
Earlier the week, policy makers began deliberations on the housing market, and specifically what to do about Fannie Mae and Freddie Mac. There are few topic more important in determining the near term prospect for economic recovery in the United States. As can be seen from the next chart mortgage finance is at the heart of the crisis. The first chart showed that mortgage balances nearly tripled from 1999 through the fall of 2007. When cracks started appearing in the mortgage market in 2006, we saw a steady increase in delinquencies. And as can be seen from the chart below, nearly all of the new credit delinquencies are mortgage related. Again, not surprising considering the expansion of consumer spending throughout the last decade was financed not by rising incomes, but rather by cash out financing. Using housing as an ATM is what has led to the problems we now face. While the prospect of easing some of those burdens is critically important toward maintaining economic order, we must be cognizant about not returning homes to their status as ATM machines.
Tim Geithner, Treasury Secretary, has made the case that government support of the housing market is essential current and future economic health. Obama administration policies to date to address distressed mortgages have been largely ineffective. The Home Affordable Modification Program (HAMP) has met with limited success. It has been very slow to take effect, and a large number of potentially eligible borrowers have failed to qualify for a variety of reasons. Notice in the above chart that slightly less than a third of eligible loans actually started a trial modification, and half of those dropped out. And, 3 million mortgages is a fraction of the number of mortgages that are underwater. So, we are left with 400K mortgages who have made it through the modification process, relative to the estimated 11.3 million underwater borrowers (Source: HUD). Since HAMP, the administration has continued to launch programs targeted at the most stressed borrowers, but as of June 88% of all loan modifications have been done outside of federal programs. And as can be seen from the table below, even after restructuring, borrowers are still highly in debt.
The white elephant in the room continued to be the agencies. There is no clear idea as to what to do with Fannie Mae and Freddie Mac. They continue to lose money at alarming rates, and if anything their market share in residential mortgages has increased in the past two years. The share of mortgages backed by government entities (which includes GNMA) has risen to 96.5%, as outside sources of finance run away from the space.
Source: Calculated Risk
Proposals for resolution of the FNMA/FHLMC crisis range from a full nationalization (aren’t we already doing that?), to a move toward full privatization. Most participants agree that longer term housing subsidies need to be reduced, but how to do so remains at issue.
There have been a number of suggestions coming out of the mortgage commission. While none of these ideas present a foolproof path to success they are worth considering. The first one worth looking at came from Bill Gross of PIMCO, a commission member. Gross suggested that all federally backed mortgage holders be given interest rate relief. What Gross proposed is to reduce any mortgage rate of 6% or higher be reduced to the current market rate of approximately 5%. One one hand this makes tremendous sense. Reducing the monthly payment of mortgage borrowers would be a big help in making housing more affordable, and should aid in reducing delinquencies. Let’s look at a quick example of how that would work. Suppose a borrower has a house worth $250,000 financed with a mortgage of the same amount at a 6% rate of interest. Under Gross’ plan the borrower would get their mortage reduced to 5%, a 1% drop. This would reduce the monthly payment for that borrower from $1500 a month to $1342 a month, a $160 a month savings. That savings would be a real incremental boost to disposable income. In theory, the consumer could take that extra $160, and pay down their mortgage with it. In doing so, they would improve their overall financial leverage, while saving thousands of future interest expenses. Additionally, theoretically such a program could raise housing prices. The theory here is that if a $1500 a month payment currently supports a $250,000 home, with lower rates the same payment could support a $280,000 home. We need to be careful with this logic as it is the same kind of reasoning that helped create the housing bubble in the first place, that is that cheap credit supports higher prices. But and it’s a big but, there is a cost. The cost is to all of the folks who lent that money, banks and bond holders. If you held a 6% FNMA mortgage, it would be worth $108 per $100 face amount. If that mortgage was written down to a current level of interest of 4.75%, the bond would only be worth par, or $100. You would lose 8% of your investment. This type of a program would provide a stimulus of $50 billion, and could potentially boost housing prices.
Herein lies one of the biggest issues surrounding the financial crisis. While public policy would like to assist those in need, those who saved and invested wisely bear the burden of bailing out those who overextended, and in essence would be rewarding those who did not. That moral hazard is exactly the same debate raging in Europe as saving countries such as Germany are asked to bailout financially irresponsible ones like Greece. Why be prudent financially, when you will be taxed to bail those out who are not, and why be responsible when ultimately it will be someone else’s problem. Obviously, either with Greece or with mortgages its not that simple. With millions of Americans in financial difficulty due to excess debt, how their future evolves so does the rest of the economy, and ultimately our futures as well. Strained consumers don’t spend, and if they don’t spend the economy will languish. On the other hand, it was their excess spending that got them into the problem in the first place.
Solving our current financial woes will ultimately come down to the United States’ ability to create value added jobs. 60% of all borrowers who sought loan modification through the HAMP program did so because of a loss of income, either a job loss or a reduction in hours or wages. So, it is important to realize that no matter how we solve the housing crisis, it is but one part of the problem. The task of creating jobs will no doubt be easier in an environment of healthy balance sheets. Restoring health to our collective balance sheet will entail sacrifice, and will not be easy or popular. But, we should watch policy makers carefully as they plot a course as their method for solving these issues will have important investment implications.