Home > #OWS, finance, statistics > Review: House of Debt by Atif Mian and Amir Sufi

Review: House of Debt by Atif Mian and Amir Sufi

June 12, 2014

I just finished House of Debt by Atif Mian and Amir Sufi, which I bought as a pdf directly from the publisher.

This is a great book. It’s well written, clear, and it focuses on important issues. I did not check all of the claims made by the data but, assuming they hold up, the book makes two hugely important points which hopefully everyone can understand and debate, even if we don’t all agree on what to do about them.

First, the authors explain the insufficiency of monetary policy to get the country out of recession. Second, they suggest a new way to structure debt.

To explain these points, the authors do something familiar to statisticians: they think about distributions rather than averages. So rather than talking about how much debt there was, or how much the average price of houses fell, they talked about who was in debt, and where they lived, and which houses lost value. And they make each point carefully, with the natural experiments inherent in our cities due to things like available land and income, to try to tease out causation.

Their first main point is this: the financial system works against poor people (“borrowers”) much more than rich people (“lenders”) in times of crisis, and the response to the financial crisis exacerbated this discrepancy.

The crisis fell on poor people much more heavily: they were wiped out by the plummeting housing prices, whereas rich people just lost a bit of their wealth. Then the government stepped in and protected creditors and shareholders but didn’t renegotiate debt, which protected lenders but not borrowers. This is a large reason we are seeing so much increasing inequality and why our economy is stagnant. They make the case that we should have bailed out homeowners not only because it would have been fair but because it would have been helpful economically.

The authors looked into what actually caused the Great Recession, and they come to a startling conclusion: that the banking crisis was an effect, rather than a cause, of enormous household debt and consumer pull-back. Their narrative goes like this: people ran up debt, then started to pull back, and and as a result the banking system collapsed, as it was utterly dependent on ever-increasing debt. Moreover, the financial system did a very poor job of figuring out how to allocate capital and the people who made those loans were not adequately punished, whereas the people who got those loans were more than reasonably punished.

About half of the run-up of household debt was explained by home equity extraction, where people took out money from their home to spend on stuff. This is partly due to the fact that, in the meantime, wages were stagnant and home equity was a big thing and was hugely available.

But the authors also made the case that, even so, the bubble wasn’t directly caused by rising home valuations but rather to securitization and the creation of “financial innovation” which made investors believe they were buying safe products which were in fact toxic. In their words, securities are invented to exploit “neglected risks” (my experience working in a financial risk firm absolutely agrees to this; whenever you hear the phrase “financial innovation,” please interpret it to mean “an instrument whose risk hides somewhere in the creases that investors are not yet aware of”).

They make the case that debt access by itself elevates prices and build bubbles. In other words, it was the sausage factory itself, producing AAA-rated ABS CDO’s that grew the bubble.

Next, they talked about what works and what doesn’t, given this distributional way of looking at the household debt crisis. Specifically, monetary policy is insufficient, since it works through the banks, who are unwilling to lend to the poor who are already underwater, and only rich people benefit from cheap money and inflated markets. Even at its most extreme, the Fed can at most avoid deflation but it not really help create inflation, which is what debtors need.

Fiscal policy, which is to say things like helicopter money drops or added government jobs, paid by taxpayers, is better but it makes the wrong people pay – high income earners vs. high wealth owners – and isn’t as directly useful as debt restructuring, where poor people get a break and it comes directly from rich people who own the debt.

There are obstacles to debt restructuring, which are mostly political. Politicians are impotent in times of crisis, as we’ve seen, so instead of waiting forever for that to happen, we need a new kind of debt contract that automatically gets restructured in times of crisis. Such a new-fangled contract would make the financial system actually spread out risk better. What would that look like?

The authors give two examples, for mortgages and student debt. The student debt example is pretty simple: how quickly you need to pay back your loans depends in part on how many jobs there are when you graduate. The idea is to cushion the borrower somewhat from macro-economic factors beyond their control.

Next, for mortgages, they propose something the called the shared-responsibility mortgage. The idea here is to have, say, a 30-year mortgage as usual, but if houses in your area lost value, your principal and monthly payments would go down in a commensurate way. So if there’s a 30% drop, your payments go down 30%. To compensate the lenders for this loss-share, the borrowers also share the upside: 5% of capital gains are given to the lenders in the case of a refinancing.

In the case of a recession, the creditors take losses but the overall losses are smaller because we avoid the foreclosure feedback loops. It also acts as a form of stimulus to the borrowers, who are more likely to spend money anyway.

If we had had such mortgage contracts in the Great Recession, the authors estimate that it would have been worth a stimulus of $200 billion, which would have in turn meant fewer jobs lost and many fewer foreclosures and a smaller decline of housing prices. They also claim that shared-responsibility mortgages would prevent bubbles from forming in the first place, because of the fear of creditors that they would be sharing in the losses.

A few comments. First, as a modeler, I am absolutely sure that once my monthly mortgage payment is directly dependent on a price index, that index is going to be manipulated. Similarly as a college graduate trying to figure out how quickly I need to pay back my loans. And depending on how well that manipulation works, it could be a disaster.

Second, it is interesting to me that the authors make no mention of the fact that, for many forms of debt, restructuring is already a typical response. Certainly for commercial mortgages, people renegotiate their principal all the time. We can address the issue of how easy it is to negotiate principal directly by talking about standards in contracts.

Having said that I like the idea of having a contract that makes restructuring automatic and doesn’t rely on bypassing the very real organizational and political frictions that we see today.

Let me put it this way. If we saw debt contracts being written like this, where borrowers really did have down-side protection, then the people of our country might start actually feeling like the financial system was working for them rather than against them. I’m not holding my breath for this to actually happen.

Categories: #OWS, finance, statistics
  1. jkw
    June 12, 2014 at 9:47 am

    I’m not sure I understand the debt restructuring. It sounds to me like if the average house price goes down, your payments are lowered, but only your individual house price matters for the lender to claim some of the gain. That is clearly biased against the borrower. Either both should be based on the individual house price or both should be based on a price index.

    Also, there is a company that will buy an equity stake in your home. They don’t put their agreement online, so I haven’t been able to determine if the terms are any good. The company is firstrex, and a quick web search turns up lots of negative comments on their offering.

  2. June 12, 2014 at 9:48 am

    Tinkering with debt is oiling the deck chairs on the Titanic.

    What is needed is to eliminate debt as the structure of the financial system. Which means eliminating banks as we know them today.

    People are now talking about the basic wage, it was first proposed in 1924 as Social Credit. The financial industry will fight this tooth and nail. We the people have to stand up and demand change.

  3. cat
    June 12, 2014 at 10:02 am

    “…the people of our country might start actually feeling like the financial system was working for them rather than against them”

    People can tell when a system is inherently not fair. The mortgage market we have now where you can’t restructure your mortgage because its not in the interest of 1 of the 3 parties involved is infuriating and unfair.

    I agree with you that the finance companies will be gaming these index’s to screw the consumers because its in their best interest to and we will have a market that does a disservice to the public.

    I think the free market experiment with home mortgages has failed. Its time to nationalize it. The income stream from that can go to fixing our failed free market experiment with college education and our about to fail primary education system.

  4. Min
    June 12, 2014 at 1:26 pm

    “The authors looked into what actually caused the Great Recession, and they come to a startling conclusion: that the banking crisis was an effect, rather than a cause, of enormous household debt and consumer pull-back.”

    The same dynamic was in effect leading up to the Great Depression. Wrote Marriner Eccles, Fed chair during the Great Depression:

    “A mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth – not of existing wealth, but of wealth as it is currently produced – to provide men with buying power equal to the amount of good and services offered by the nation’s economic machinery. Instead of achieving that kind of distribution, a giant suction pump had by 1929-1930 drawn into a few hands an increasing portion of currently produced wealth. This served them as capital accumulations. But by taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.” (Found at http://www.nakedcapitalism.com/2010/10/has-the-fed-painted-itself-into-a-corner.html )

    In testimony before the Senate in 1933 Eccles said this, which seems pertinent today:

    “How was it that during the period of the prosperity after the war we were able in spite of what is termed our extravagance – which was not extravagance at all; we saved too much and consumed too little – how was it we were able to balance a $4,000,000,000 annual Budget, to pay off ten billion of the Government debt, to make four major reductions in our income tax rates (otherwise all of the Government debt would have been paid), to extend $10,000,000,000 credit to foreign countries represented by our surplus production which we shipped abroad, and add approximately $100,000,000,000 by capital accumulation to our national wealth, represented by plants, equipment, buildings, and construction of all kinds? In the light of this record, is it consistent for our political and financial leadership to demand at this time a balanced Budget by the inauguration of a general sales tax, further reducing the buying power of our people? Is it necessary to conserve Government credit to the point of providing a starvation existence for millions of our people in a land of superabundance? Is the universal demand for Government economy consistent at this time? Is the present lack of confidence due to an unbalanced Budget?”

    Eccles starts off by referring to the period after WWI, but which rings true for the Clinton and Bush years. We were projected to pay off the national debt, but for the Bush tax cuts and war spending. His main point about gov’t austerity still holds true. It reduces the buying power of our people and spreads suffering.

    Here is another similarity between now and the Great Depression: a concentration of money which is not being invested or used to hire people. From Eccles’s testimony:

    “If it is credit we need why do not say 200 of our great corporations controlling 40 per cent of our industrial output that are in such shape that they do not need credit – they have great amounts of surplus funds – if it is credit that is needed why do they not put men to work? For the very reason that there is not a demand for goods, that we have destroyed the ability to buy at the source through the operation of our capitalistic system, which has brought about such a maldistribution of wealth production that it has gravitated and gravitated into the hands of – well, comparatively few. Maybe several millions of people. We have still got the unemployment and have got no buying power as a result.”

  5. josh
    June 13, 2014 at 12:14 pm

    The idea of having debt adjust to economic circumstances has been around for some time. Robert Shiller has pushed it under the name “continuous workout mortgage”. http://www.nytimes.com/2008/09/21/business/21view.html?_r=0

    Looking forward, student debt is having the same kind of depressing effect now (and likely to get worse). Elizabeth Warren has a proposal for capping student debt payments as a percentage of income that is similar to these ideas.

    I think these ideas have some promise. But I was much more optimistic about financial engineering fixes 10 years ago than I am now.

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