Do the Math on Recession and Foreclosures

Thanks to CreditSlips for inviting me to be a guest blogger and to share my views on credit and the economy.

By now, it's obvious that the housing crisis is dragging down the economy. For the past eight quarters, the declining activity in the housing market dampened growth on average by 0.9 percentage points below where it otherwise would have been. This is the largest housing induced subtraction from economic growth since 1975.

Some observers argue that this is just a natural correction of the market and that policy makers should let market forces play themselves out. The logic is that a nice, quick recession will get rid of the debt overhang by forcing people to default. Once banks’ balance sheets are free of the excess loans, the economy will get a clean slate to start over again as a rejuvenated banking sector will once again pave the way for innovation and production and not for speculation and Wall Street greed. The way it is portrayed, it almost sounds like a day at the spa for the US economy.

The situation, though, is far more serious. A recession that would get rid of the debt overhang would have to be very deep, especially since the mortgage foreclosure rate would have to jump to unimaginably high rates.

Nobody needs to be an economic forecaster to understand this. All it takes is a healthy dose of good old fashioned common sense, and a calculator.

How much of the debt that families owe right now is too much? To answer this, we need a benchmark that tells us how much debt should have grown. If debt has grown faster than the benchmark, there is too much debt and the amount above the benchmark is the amount that a recession should eradicate.

Debt can grow along with economic and income growth. Hence, I use the ratio of debt to income. By September 2007, families owed 133.0% of their after-tax income in all forms of debt – mortgages, credit cards, car loans, and so on. This ratio had risen each quarter by 1.4 percentage points from March 2001, when the last recession started, to September 2007. This increase was more than four times faster than the growth of debt in the 1990s.

Already, there is some sense that there is too much debt. If debt relative to disposable income had grown from March 2001 to September 2007 at the same rate as it did in the 1990s, it would have amounted to 110.1% of disposable income in September 2007. The difference to the actual level of debt is 22.2% of after tax income, or $2.35 trillion.

This may not be "too much," if the accelerated debt can be explained by sharper drops in interest rates. This was not the case. In the 2000s, mortgage interest rates fell by 8.2% from 7.0% in March 2001 to 6.4% in September 2007. During the intervening period, mortgage interest rates fell as far as 5.6% -- or 19.7% below the level in March 2001. By comparison, over the course of the business cycle in the 1990s, mortgage rates fell by 30.8% and the swing from the beginning of the last business cycle to the low point of mortgage rates was 33.2%. Clearly, mortgage rates dropped much more in the 1990s than in the 2000s and debt growth should have been slower, not faster after 2001.

Also, much of the growth in mortgages in the 2000s was in subprime mortgages, meaning that more and more borrowers paid a premium. Consumers faced substantially smaller declines in the cost of debt after 2000 than in the 1990s.

So, the estimate of "too much debt" of $2.35 trillion is probably a good starting point.

Now, the "clean slate" argument says that the economy should go into recession to get rid of the debt overhang. A recession will turn a lot of marginal debt into bad debt since people will lose their jobs or have lower wages. That naturally precludes the path of faster income growth to reducing the debt-to-income ratio. It also means that people won't be paying off their existing debt faster than in the past. The only other path that is left is debtor default.

To get rid of $2.35 trillion dollars in debt, the economy would have to experience a massive wage – or more a tsunami – of foreclosures. This amount is equal to 22.3% of mortgages. Spread out over two years, it implies an approximate default rate of 3% of all outstanding mortgages each quarter for eight quarters. This is about four times larger than the current record rate of mortgages entering foreclosure each quarter. Even trying to cut the debt overhang into half would require a doubling of the foreclosure rate from their current record high levels for each of the next eight quarters. There is no telling what this would do for banks, the stock market, the economy and jobs.

Clearly, letting the housing market and the economy go into free fall is not a viable answer. The risks to the financial health of families are simply too high. The economy needs a dual solution. For one, income has to grow faster and families need to work out solutions for the mortgages that they cannot pay.

Comments

[silverbug]

income has to grow faster--okay, gimme a raise

[mia]

Growing my income as fast as I can - a dollar saved is a dollar earned, renting out the spare bedrooms, and getting a second job all help.

[Mike Dillon]

Dr. Weller, what do you recommend that the hundreds of thousands of homeowners facing ILLEGAL foreclosures do in order to save their homes?

Granted, I'm basing that figure on data amassed over the last few years based on class action participants but since nothing has happened to regulate the mortgage servicing industry I can only assume that the estimation is accurate.

[Don]

"growing income faster"--that's easy, just print more money. Oh wait, they're doing that already. It won't mean anything real has changed, but it is oh-so-less depressing than getting poorer the other way 'round-- where the actual income declines.

I don't think our economic model is sustainable long term. No economic system, be it country, business, or family, ever got rich borrowing money. They might have sometimes appeared rich, but just like your neighbor w/ the new German sports car, it really just shows a propensity to mortgage the future for today's short-term gratification.

[Vlad Makarov]

If 22% of families are to be foreclosed upon, so be it. Free market at work. Those with limited means should not have borrowed too much, making housing way too expensive for the rest of us who work hard and refuse to take on debt.

[Mike Dillon]

Now imagine, Vlad, that the home that you are "working hard" for is suddenly stripped away from you through no fault of your own. You're current on your payments, you're up to date on your insurance - but the entity servicing your loan says that you're still behind in your payments, and NOW you're in default and scheduled for a foreclosure auction in three weeks.

OR, the loan that you signed at closing was a fixed rate that you could afford. Only problem is that when your first monthly statement arrives, the payment amount is way off...Or the interest rate is more than what you agreed to. But now, you're way past the three day right of rescission and 30-60 days down the road...

Sounds like you've got perfect 20/20 hindsight but you may want to widen out that narrow perception just a tad.

And it is absolutely imperative that each case is looked at individually because it's not JUST the borrowers that are to blame... It's not JUST the brokers...It's not just the underwriters... It's a combination of factors across the board. HOWEVER, borrowers would not have been able to purchase "too much house" if the loan products weren't created for them and if the brokers had not been motivated to make as much money off of each loan as possible. Anyone who thinks that the borrowers have caused the current crisis really needs to sit down and start reading...

[Jake]

What many people fail to realize is that people who 'lose their houses' can now rent at half the price...just like they did before they took out the ill-advised mortgage, which they could not afford. I contend the path the Fed chose, hyper-inflating the economy, which btw, started this mess in the first place, will lead to more homelessness than allowing houses prices to deflate to affordable levels. My profuse apologies for the run-on sentences.

[Patricia Smith]

Preditory lenders should be prosicuted to the fullest extent of the law. These people have prey upon the black economy more than the whites. Then people condem the black people for taking out loans above their income. Maybe if their were fair and equal justice in our laws, when a crime is commited upon an individual, they should pay back the money and face jail time. The fact that the majority of black, low income neighborhoods being affected that same old rime "let forget about prosecution, we all know who these big preditory firm are, and just look the other way, now the new talk is let get these same people who stole before try to help the same people again stating talk to me i will help with the problem... The problem is in the system not convicting the right crimminals, letting them prey over and over again.