Fighting over Claims

This brief segment from a recent speech by Joe Stiglitz sums up very neatly the nature of our current economic predicament (emphasis added):

We should realize that the resources in our economy... today is the same is at was five years ago. We have the same human capital, the same physical capital, the same natural capital, the same knowledge... the same creativity... we have all these strengths, they haven't disappeared. What has happened is, we're having a fight over claims, claims to resources. We've created more liabilities... but these are just paper. Liabilities are claims on these resources. But the resources are there. And the fight over the claims is interfering with our use of the resources.

I think this is a very useful way to think about the potential effectiveness under current conditions of various policy proposals, including conventional fiscal and monetary stabilization policies.

Part of the reason for our anemic and fitful recovery is that contested claims, especially in the housing market, continue to be settled in a chaotic and extremely wasteful manner. Recovery from subprime foreclosures is typically a small fraction of outstanding principal, and properly calibrated principal write-downs can often benefit both borrowers and lenders. Modifications that would occur routinely under the traditional bilateral model of lending are much harder to implement when lenders are holders of complex structured claims on the revenues generated by mortgage payments. Direct contact between lenders and borrowers is neither legal nor practicable in this case, and the power to make modifications lies instead with servicers. But servicer incentives are not properly aligned with those of the lenders on whose behalf they collect and process payments. The result is foreclosure even when modification would be much less destructive of resources.

Despite some indications that home values are starting to rise again, the steady flow of defaults and foreclosures shows no sign of abating. Any policy that stands a chance of getting us back to pre-recession levels of resource utilization has to result in the quick and orderly settlement of these claims, with or without modification of the original contractual terms. And it's not clear to me that the blunt instruments of conventional stabilization policy can accomplish this.

Consider monetary policy for instance. The clamor for more aggressive action by the Fed has recently become deafening, with a long and distinguished line of advocates (see, for instance, recent posts by Miles Kimball, Joseph Gagnon, Ryan Avent, Scott Sumner, Paul Krugman, and Tim Duy). While the various proposals differ with respect to details the idea seems to be the following: (i) the Fed has the capacity to increase inflation and nominal GDP should it choose to do so, (ii) this can be accomplished by asset purchases on a large enough scale, and (iii) doing this would increase not only inflation and nominal GDP but also output and employment.

It's the third part of this argument with which I have some difficulty, because I don't see how it would help resolve the fight over claims that is crippling our recovery. Higher inflation can certainly reduce the real value of outstanding debt in an accounting sense, but this doesn't mean that distressed borrowers will be able to meet their obligations at the originally contracted terms. In order for them to do so, it is necessary that their nominal income rises, not just nominal income in the aggregate. And monetary policy via asset purchases would seem to put money disproportionately in the pockets of existing asset holders, who are more likely to be creditors than debtors. Put differently, while the Fed has the capacity to raise nominal income, it does not have much control over the manner in which this increment is distributed across the population. And the distribution matters.

Similar issues arise with inflation. Inflation is just the growth rate of an index number, a weighted average of prices for a broad range of goods and services. The Fed can certainly raise the growth rate of this average, but has virtually no control over its individual components. That is, it cannot increase the inflation rate without simultaneously affecting relative prices. For instance, purchases of assets that drive down long term interest rates will lead to portfolio shifts and an increase in the price of commodities, which are now an actively traded asset class. This in turn will raise input costs for some firms more than others, and these cost increases will affect wages and prices to varying degrees depending on competitive conditions. As Dan Alpert has argued, expansionary monetary policy under these conditions could even "collapse economic activity, as limited per capita wages are shunted to oil and food, rather than to more expansionary forms of consumption."

I don't mean to suggest that more aggressive action by the Fed is unwarranted or would necessarily be counterproductive, just that it needs to be supplemented by policies designed to secure the rapid and efficient settlement of conflicting claims.

One of the most interesting proposals of this kind was floated back in October 2008 by John Geanakoplos and Susan Koniak, and a second article a few months later expanded on the original. It's worth examining the idea in detail. First, deadweight losses arising from foreclosure are substantial:

For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line... there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.

Second, securitization precludes direct contact between borrowers and lenders:

In the old days, a mortgage loan involved only two parties, a borrower and a bank. If the borrower ran into difficulty, it was in the bank’s interest to ease the homeowner’s burden and adjust the terms of the loan. When housing prices fell drastically, bankers renegotiated, helping to stabilize the market.

The world of securitization changed that, especially for subprime mortgages. There is no longer any equivalent of “the bank” that has an incentive to rework failing loans. The loans are pooled together, and the pooled mortgage payments are divided up among many securities according to complicated rules. A party called a “master servicer” manages the pools of loans. The security holders are effectively the lenders, but legally they are prohibited from contacting the homeowners.

Third, the incentives of servicers are not aligned with those of lenders:

Why are the master servicers not doing what an old-fashioned banker would do? Because a servicer has very different incentives. Most anything a master servicer does to rework a loan will create big winners but also some big losers among the security holders to whom the servicer holds equal duties... By allowing foreclosures to proceed without much intervention, they avoid potentially huge lawsuits by injured security holders.

On top of the legal risks, reworking loans can be costly for master servicers. They need to document what new monthly payment a homeowner can afford and assess fluctuating property values to determine whether foreclosing would yield more or less than reworking. It’s costly just to track down the distressed homeowners, who are understandably inclined to ignore calls from master servicers that they sense may be all too eager to foreclose.

And finally, the proposed solution:

To solve this problem, we propose legislation that moves the reworking function from the paralyzed master servicers and transfers it to community-based, government-appointed trustees. These trustees would be given no information about which securities are derived from which mortgages, or how those securities would be affected by the reworking and foreclosure decisions they make.

Instead of worrying about which securities might be harmed, the blind trustees would consider, loan by loan, whether a reworking would bring in more money than a foreclosure... The trustees would be hired from the ranks of community bankers, and thus have the expertise the judiciary lacks...

Our plan does not require that the loans be reassembled from the securities in which they are now divided, nor does it require the buying up of any loans or securities. It does require the transfer of the servicers’ duty to rework loans to government trustees. It requires that restrictions in some servicing contracts, like those on how many loans can be reworked in each pool, be eliminated when the duty to rework is transferred to the trustees... Once the trustees have examined the loans — leaving some unchanged, reworking others and recommending foreclosure on the rest — they would pass those decisions to the government clearing house for transmittal back to the appropriate servicers...

Our plan would keep many more Americans in their homes, and put government money into local communities where it would make a difference. By clarifying the true value of each loan, it would also help clarify the value of securities associated with those mortgages, enabling investors to trade them again. Most important, our plan would help stabilize housing prices.

As with any proposal dealing with a problem of such magnitude and complexity, there are downsides to this. Anticipation of modification could induce borrowers who are underwater but current with their payments to default strategically in order to secure reductions in principal. Such policy-induced default could be mitigated by ensuring that only truly distressed households qualify. But since current financial distress is in part a reflection of past decisions regarding consumption and saving, some are sure to find the distributional effects of the policy galling. Nevertheless, it seems that something along these lines needs to be attempted if we are to get back to pre-recession levels of resource utilization anytime soon. And the urgency of action does seem to be getting renewed attention.

The bottom line, I think, is this: too much faith in the traditional tools of macroeconomic stabilization under current conditions is misplaced. One can conceive of dramatically different approaches to monetary policy, such as direct transfers to households, but these would surely face insurmountable legal and political obstacles. It is essential, therefore, that macroeconomic stabilization be supplemented by policies that are microeconomically detailed, fine grained, and directly confront the problem of balance sheet repair. Otherwise this enormously costly fight over claims will continue to impede the use of our resources for many more years to come.