Efficient Credit Policies in a Housing Debt Crisis
Consumption, income, and home prices fell simultaneously during the financial crisis, compounding recessionary conditions with liquidity constraints and mortgage distress. We develop a framework to guide government policy in response to crises in cases when government may intervene to support distressed mortgages. Our results emphasize three aspects of efficient mortgage modifications. First, when households are constrained in their borrowing, government resources should support household liquidity up-front. This implies modifying loans to reduce payments during the crisis rather than reducing payments over the life of the mortgage contract, such as via debt reduction. Second, while governments will not find it efficient to directly write down the debt of borrowers, in many cases it will be in the best interest of lenders to do so, because reducing debt is an effective way to reduce strategic default. Moreover, the lenders who bear the credit default risk have a direct incentive to partially write down debt and avoid a full loan loss due to default. Finally, a well-designed mortgage contract should take these considerations into account, reducing payments during recessions and reducing debt when home prices fall. We propose an automatic stabilizer mortgage contract which does both by converting mortgages into lower-rate adjustable-rate mortgages when interest rates fall during a downturn—reducing payments and lowering the present value of borrowers’ debt.
Loading...