House of Debt

Atif Mian and Amir Sufi “House of Debt: How They (and You) Caused the Great Recession…,  Univ. of Chicago Press, 2014, 190 pp.

The Great American Recession resulted in the loss of eight million jobs between 2007 and 2009. More than four million homes were lost to foreclosures. This well-researched book links this Great Recession with the doubling of household debt between 2000 and 2007 to $14 trillion from $7 trillion, effectively raising the debt-to-income ratio from 1.4 to 2.1.  Atif Mian and Amir Sufi reveal in House of Debt how the Great Recession and Great Depression, as well as the current economic malaise in Europe, were caused by a large run-up in household debt followed by the resulting large drop in household spending.  They additionally argue that current policy is too heavily biased toward protecting banks and creditors. Increasing the flow of credit, they show, is disastrously counterproductive when the fundamental problem is too much debt.

The theme of this book is that recessions are not inevitable—“they are not mysterious acts of nature that we must accept.  Instead, recessions are a product of a financial system that fosters too much household debt.  Economic disasters are man-made, and the right framework can help us understand how to prevent them”. (P. 13) The financial system should adopt more equity-like contracts that are made contingent on risks outside the control of households.  Investors should earn a return for bearing those risks, and households should be protected when those risks materialize.  The government should stop subsidizing the use of inflexible debt contracts, both in the banking and household sectors. (P. 186).

My Notes:

Pg. 2:  If it were not for the Great Recession, the income of the US in 2012 would have been higher by $2 trillion, around $17,000 per household.  Workers who are laid off during recessions lose on average three full years of lifetime income potential. 

Pg. 9:  Taken together, both the international and US evidence reveals a strong pattern: Economic disasters are almost always preceded by a large increase in household debt.

Pg. 21:  From 2006 to 2009, house prices for the nation as a whole fell 30 percent.  And they stayed low, only barely recovering toward the end of 2012.  This collapse in house prices hit low net-worth households the hardest because their wealth was tied exclusively to home equity.

Pg. 26:  In 2011, 11 million properties—23 percent of all properties with a mortgage—had negative equity.  Foreclosures were three times higher than the last peak before the recession: about 5 percent of all mortgages were in foreclosure in 2009.  It is estimated that between 30 and 40 percent of all home sales in 2009 and 2010 were foreclosures or short sales.

Pg. 96:  The traditional neighborhood-banking model, where banks kept the home-loans known to George Bailey in A Wonderful Life, was excellent for giving lenders more information about borrowers, but it was especially vulnerable to local risks.  Recognizing this weakness in the mortgage market, in 1970 the US Department of Housing and Urban Development promoted securitization through government-sponsored enterprises (GSEs) to give local banks a way to sell off their neighborhood mortgages to the GSEs and avoid worrying about exposure to local market risk.  To minimize the risk of banks selling poor-quality mortgages to the GSEs, the GSEs mandated minimum ‘conforming’ requirements like limits on loan sizes and strict loan-to-value ratios.  These securitized mortgage-backed securities (MBSs) were then sold with the GSE’s keeping a cut from the interest payments to insure MBS holders against the risk of default.

However, as the global appetite for safe US debt began to skyrocket in the late 1990s, the strict GSE requirements were limiting mortgages available for securitization.  As a result, the demand could only be met by the non-GSE private market—if only the private market could somehow create low-risk MBS from a pool of non-conforming mortgages.  This miracle was achieved through tranching, which slices a pool of mortgages into different layers that define how MBS investors line up to receive payments.  The most senior tranche is the safest as it has the first right to payments coming from the underlying mortgages.

Pg. 136:  In 2008 a number of programs to ease household-debt burdens, included the Home Affordable Modification Program.  It was supposed to help 3 to 4 million at-risk homeowners avoid foreclosure.  Five years later, it had led to only 860,000 permanent modifications.  The Treasury spent less than 2 percent of TARP funds on homeowner relief programs.  In contrast, it spent 75 percent of TARP funds to rescue financial institutions. 

Pg. 167:  Outstanding student debt doubled from 2005 to 2010, and by 2012 total student debt in the US economy surpassed $1 trillion.  Two-thirds of bachelor’s degree recipients borrowed money from either the government or private lenders.  Also, student debt cannot be discharged in bankruptcy.  And the government can garnish your wages or take part of your tax refund or Social Security payments to ensure that they get paid on federal loans.

Pg. 171: A Shared-Responsibility Mortgage (SRM) has two important differences from a standard mortgage contract: (1) the lender offers downside protection to the borrower, and (2) the borrower gives up 5 percent capital gain to the lender on the upside.

Pg. 173:  House prices in the US have historically grown at an annual rate of 3.1 percent, with a standard deviation of 8.3 percent.  (I believe this is a nominal rate, unadjusted for inflation).  Based on this, an SRM implies that lenders will charge about 1.4 percent of the initial mortgage amount as downside protection fee from the borrower.  However, we can eliminate this extra charge by giving the lender a small share in the upside as well, probably about 5 percent.

LINK: (The average annual home price increase for the U.S. during the whole 1900 - 2012 period was only 3.1%/year -- just a shade better than the inflation rate of 3.0%/year.)