Did the response to the financial crisis focus too much on banks while neglecting over-indebted homeowners? House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again, by Atif Mian and Amir Sufi, University of Chicago Press.
House of Debt focuses on the deterioration of household balance sheets, an analysis that has profound implications for policy directed both at preventing crises and responding to them when prevention fails.
The book examines a profoundly important question: what causes protracted downturns in economic activity? They have marshalled new data – for example, on spending by zip code – to test their hypotheses, assembling such a range of evidence from so many different sources that their conclusions are not susceptible to challenge by those looking to point out statistical errors.
Most in the financial community, the policy community and the commentariat see a breakdown in financial intermediation as the root cause of the financial crisis and Great Recession. The failure to bail out Lehman Brothers is usually viewed as the prelude to
The authors argue that, rather than failing banks, the key culprits in the financial crisis were overly indebted households. They highlight how harsh leverage and debt can be – for example, when the price of a house purchased with a 10 per cent downpayment goes down by 10 per cent, all of the owner’s equity is lost. They demonstrate powerfully that spending fell much more in parts of the country where house prices fell fastest and where the most mortgage debt was attached to homes. So their story of the crisis blames excessive mortgage lending, which first inflated bubbles in the housing market and then left households with unmanageable debt burdens. These burdens in turn led to spending reductions and created an adverse economic and financial spiral that ultimately led financial institutions to the brink.
Households do not spend while they are still overly indebted, which precipitates slow growth even after banking is restored to health. Spending slowdowns are caused by household over-indebtedness, so of course they precede problems in the banking system. And, when consumers do not spend, businesses have less need to borrow to finance investment, inventories or receivables.
Their analysis, presented with far more depth and subtlety than I have been able to reflect here, is a major contribution that furthers our understanding of the crisis. It certainly affects what I will examine in trying to predict and forestall future crises. And it should influence policies aimed at crisis prevention by demonstrating the insufficiency of keeping financial institutions healthy and by making a case for macroprudential measures directed at preventing runaway growth in household debt.
With hindsight some argue that more pain should have been imposed on the financial sector. In the moment, though, the overwhelming imperative was restoring confidence at a time when complete breakdown looked like a real possibility. The government got back substantially more money than it invested. All of the senior executives who created these big messes were out of their jobs within a year. And stockholders lost 90 per cent or more of their investments in all the institutions that required special treatment by the government.
Reducing mortgage debt would have spurred spending. The idea of “cram-down”: the notion that bankruptcy judges should be allowed to write down mortgage debt, and that permitting them to do so would increase the bargaining power of homeowners seeking relief probably would have worked.
Critics who disagree at this late date are obliged to provide an alternative analysis of the political calculus, not a mere recitation of the arguments for cram-down. In the US at the time of the crisis there was no political will to do “cram-down.”
Banks had substantial mortgage holdings and especially large quantities of subordinated second mortgages and home equity lines of credit, which would have been wiped out if mortgage principal had been reduced in a way that respected the seniority of first mortgages. We recognised that large-scale principal reduction would draw in a large number of mortgages that were not delinquent and would otherwise be paid in full. As a consequence, there was the risk of sucking hundreds of billions of dollars out of the banking system. Given that government funds for capital infusions were scarce and that each dollar of bank capital supports $12 of lending, we worried that the spending gains from reducing mortgage debt might well be exceeded by the spending losses from reducing the flow of capital. This fear may have been exaggerated. If they think so, Mian and Sufi owe an explanation as to why.
Future lending might have been chilled. The housing market’s problems might have been prolonged. If the government had bought underwater mortgages from banks.
There was the danger of prolonging the housing market’s problems. Even the relatively limited programmes in place have spent as much as a third of their money delaying, rather than avoiding, foreclosures. All that we heard at the time suggested that a significant part of the reason why the housing market was dead was that no one wanted to buy because of a fear that it had further to fall. Delaying inevitable foreclosures with relief risked exacerbating this problem and risked larger foreclosure discounts when houses were ultimately sold.
In many cases mortgage assets were carried on banks’ books at valuations far above what appeared to be current market value. Buying them at such valuations would have been a massive backdoor subsidy to banks of the kind we would not accept. All future work on financial crises will have to reckon with the household balance sheet effects the authors stress.
