The Hindu Business Line : ‘Lender could worsen downturn in asset prices’

Bangalore, Dec. 9 Housing prices in the US have fallen by a third since 2006, as a result of which home mortgage amounts are estimated to exceed the value of collateral by about $1 trillion.

How mortgage claims are restructured is an issue that can have major macroeconomic consequences. Should the Government leave it to lenders to work out recovery and relief packages in a recession, or intervene by taking over the debts or paying them off? A recent paper, “A Depressing Scenario: Mortgage Debt becomes Unemployment Insurance,” by Casey B. Milligan (NBER Working Paper 14514) makes a case for the Government to get into the picture.

Why? When asset values fall and the threat of large-scale default looms large, lenders recover their dues in a way so as to favour those who are less productive, and therefore earn less.

If a lender makes a claim on a percentage of the borrower’s income, in effect imposing a tax, he is adding to the tax burden of the borrower whose productivity and wage levels are high. The less productive borrower, earning less, will be paying lower tax to the Treasury, and may even get away with a lower outgo to the lender, even as the lender is conscious of the moral hazard of letting off the worse-off borrower.

The burden of the paper is to explain that the lender wants to tailor its amnesty for worse-off borrowers in such a way as not to create bad incentives for the rest, but is unable to achieve this. In the process, the more productive workers are discouraged from earning more. A decline in asset prices is transmitted into the real economy, adversely impacting employment and income.

Governments thus have an incentive to alleviate this phenomenon, the paper argues, by one of many ways. It can regulate the quantum of debt forgiveness by a lender on the ground that any differential treatment across consumers is a form of price discrimination. Alternatively, it can repudiate some of the debt, or cut taxes, or acquire the debt in the marketplace,” the paper observes.

Citing the case of Citigroup, which has announced debt forgiveness as a percentage of the borrower’s gross income, the paper says that if this figure were to be hypothetically considered a borrower’s efforts to increase his income by 25 per cent would increase his payment obligation by the same per cent — in effect an additional 25 per cent tax rate at the margin.

The paper, which examines the impact of debt forgiveness on labour income, says that the same pattern is likely to be observed if other dependent variables such as asset holdings and family structures are taken into consideration: “Borrowers will have the incentive to seek the levels of assets and to seek the family structures that offer more forgiveness rather than less.” It may cause people to “stay at a residence longer than is efficient”. Therefore, lender behaviour could exacerbate a downturn in asset prices.

Lender behaviour tends to be pro-cyclical rather than counter-cyclical; hence, the need for Government intervention.

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