Saturday, June 30, 2012

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 KimballJoseph Gagnon, Ryan AventScott 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.


  1. superb sir superb

    i hope you in a later post
    the keen difference between QE
    and fiscal policy

  2. paine, welcome back... haven't heard from you in a while. I wanted to talk about fiscal policy and debt capacity but the post was already too long. In any case, I need to sort out my thoughts a bit more on that front. I've linked to posts by @interfluidity and @macroresilience that address fiscal policy by monetary means. This would be hugely effective but has zero chance of being implemented.

  3. sethi links to this

    "A quantitative easing program focused on purchasing private sector assets is essentially a fiscal program in monetary disguise and is not even remotely neutral in its impact on income distribution and economic activity. Even if the central bank buys a broad index of bonds or equities, such a program is by definition a transfer of wealth towards asset-holders and regressive in nature (financial assets are largely held by the rich). The very act of making private sector assets “safe” is a transfer of wealth from the taxpayer to some of the richest people in our society. The explicit nature of the central banks’ stabilisation commitment means that the rent extracted from the commitment increases over time as more and more economic actors align their portfolios to hold the stabilised and protected assets.

    Such a program is also biased towards incumbent firms and against new firms. The assumption that an increase in the price of incumbent firms’ stock/bond price will flow through to lending and investment in new businesses is unjustified due to the significantly more uncertain nature of new business lending/investment. This trend has been exacerbated since the crisis and the bond market is increasingly biased towards the largest, most liquid issuers. Even more damaging, any long-term macroeconomic stabilisation program that commits to purchasing and supporting macro-risky assets will incentivise economic actors to take on macro risk and shed idiosyncratic risk. Idiosyncratic risk-taking is the lifeblood of innovation in any economy.

    In other words, QE is not sufficient to hit any desired inflation/NGDP target unless it is expanded to include private sector assets. If it is expanded to include private sector assets, it will exacerbate the descent into an unequal, crony capitalist, financialised and innovatively stagnant economy that started during the Greenspan/Bernanke put era."

    another link at RS's post :

    "During depressions and disinflations, the Fed should be depositing funds directly in bank accounts at a fast clip. During booms, the rate of transfers should slow to a trickle. We could reach the “zero bound”, but a different zero bound than today’s zero interest rate bugaboo. At the point at which the Fed is making no transfers yet inflation still threatens, the central bank would have to coordinate with Congress to do “fiscal policy” in the form of negative transfers, a.k.a. taxes. However, this zero bound would be reached quite rarely if we allow transfers to displace credit expansion as the driver of money growth in the economy. In other words, at the same time as we expand the use of “helicopter money” in monetary policy, we should regulate and simplify banks, impose steep capital requirements, and relish complaints that this will “reduce credit availability”. The idea is to replace the macroeconomic role of bank credit with freshly issued cash"

    notice these are moves toward ...the existing tax and transfer system

    re inventing the wheel in other words

    we can do all this now simply by redesigning the federal transfer system
    and with this aded "value"
    the system can target socially warranted citizens
    in my world that would be ocasional counter cyclical
    "earned "social dividends

    earned ?


    by career job history

  4. paine, those are both excellent posts by two of the most thoughtful bloggers out there. But what they are proposing is very different from Treasury transfers because it is not constrained by debt capacity. Treasury transfers would have to be funded either contemporaneously by taxes (which would negate some of the stimulative effect) or by issuing bonds at market (and Fed) determined rates. It's an important difference both economically and politically - the latter because of the federal debt limit.

  5. u surprised me

    i guess i always assume
    the implicit fed move
    of a pinned policy rate

    and i certainly consider tax moves in this context as on vacation

    think kalecki's classic paper

    yes indeed the fed plays
    a servo mechanism role here

    but should we really go along with this division of powers gag any way ?

    the fed is a creature of the congress not the constitution

    i'd render it servile as it was from the earnest 1940's to winter 1951

    but we are off point

    i really wanted to focus on the
    fine tuning aspect an upan running carefully drafted transfer system provides

    an explicit
    "state of the system" dependent algorithm
    could inject and extract automatically once hooked into timely feed back data streams

  6. the federal debt limit is another artifice created by congress
    that one during WWI

    the whole debt to gdp ratio circus needs some
    heavy progressive lifting

    feasiblity path to such a system as proposed above
    is a separate discussion

  7. Rajiv - great post.

    I don't deny that mine or Steve's ideas are a little bit radical - what I am baffled by is how ideas that advocate the Fed buying up private sector assets like corporate bonds/equities in significant quantities are seen as somehow the logical and non-controversial thing to do. One reason is that the NGDP targeters assume that the commitment to a target will be sufficient and no actual purchases will be needed. The experience of the SNB has already given us some contradicting evidence ( Paulson's bazooka re Fannie/Freddie 2008 was another one).

    To me, it seems the CB buying up equity ETFs is more likely than the mass mortgage principal reduction idea. And that scares me.

  8. Thanks Ashwin. It's interesting that the Fed was originally required to buy only commercial paper, which was thought to be "self-liquidating". It required a change in the Act to allow purchase of Treasuries, without which war financing would have been impossible. Yet a transition from Treasuries to mortgage backed securities and credit lines to foreign banks occurred with no real public debate and no war. Perry Mehrling's post on this is very good.

    I agree with you and Steve that direct transfers are the most effective way to conduct monetary policy in a depression, and possibly also the fairest. I think that part of the reason for resistance to it is accounting. With open market operations, there's an asset on the balance sheet regardless of whether it is privately or publicly issued. And this means that the transaction can be reversed if necessary. With direct transfers there's no asset and no reversal possible, and losses are incurred immediately.

    Maybe Fed profits, rather than going to the Treasury, should be distributed to the population at large as a dividend? In a liquidity crisis that is successfully stemmed by the Fed, such profits should be substantial. This is much more modest than your proposal but perhaps also more feasible? Just a thought.

  9. "With open market operations, there's an asset on the balance sheet regardless of whether it is privately or publicly issued. And this means that the transaction can be reversed if necessary. With direct transfers there's no asset and no reversal possible, and losses are incurred immediately"
    precisely why you want treasury to mediate the process of pay out
    ie generating treasury notes to cover the payments and the fe monetizing the notes

  10. paine, the Fed would not be monetizing the notes, because the transaction could be reversed. But in any case my point was about feasibility rather than optimality.

  11. monetizing can always be reversed ?

    thanx again for the great post
    you very concisely articulated the "class" problem
    i had with QE

  12. Dr. Sethi,

    I completely agree that macro based stabilization efforts do not directly address the true issue at hand regarding foreclosures - namely a redistribution or catalyzing of distressed homeowner income relative to their obligations and prices under current macro constraints. Your post is very intriguing. The diverging interests of the borrower, lender, and security holders are complex, however I think there is an additional benefit for lenders in pursuing foreclosure. By foreclosing, the lender is of course faced with a loss, however the obligation to security holders may seem a low cost for prime foreclosures which the bank can hold for sale at a more advantageous time. Granted, it is a doubling down for the lender, but would seem to add the to the attraction of continued foreclosures when considering the legal liabilities you indicated regarding loan restructuring. If foreclosed properties held by financial institutions were restricted to recovering only book value on the loans and a regulated scale for the recovery of maintenance costs (specifically that which allows the lender to recovery only part of the amount spent in maintaining the property between foreclosed recovery and resale), the incentive for lenders to accumulate foreclosed properties would offer no potential for future gains. This seems to me a way to provide the counter-pressure on lenders to further embrace principal (and possibly term?) restructuring efforts, however I am very much an econamateur. Very interested in your thoughts sir...

  13. Prof. Sethi,

    A quick question: if we undertook this policy and managed to modify all of the loans in question rather than allow these homes to go into foreclosure, how much of a dent would it make in the problem? How much of the fight over claims that we're facing is reserved to those homeowners facing foreclosure? How much is in other debt (credit card, student loan,...) or elsewhere in the economy?

    Additionally, wouldn't the security holders rebel against this kind of deal? With a blind trustee in charge, it might be hard for security holders to predict whether they would come out winners or losers across many deals, and cause them to push back even more strongly.