Bankruptcy

Do the Math on Recession and Foreclosures

By Christian E. Weller

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.

Full post as published by Credit Slips on February 18, 2008 (boomark / email).