Debt

Nouriel Roubini is, once again, far in front of the crowd regarding what's ailing the economy. He was the first to understand the problem, the first to predict the fall out, and now possibly the first to identify the fix. In his latest post, Roubini seems to be suggesting that the proposed bailout is targeted to the wrong group of stakeholders:

When a country (say Russia, Ecuador or Argentina) has too much debt and is insolvent it defaults and gets debt reduction and is then able to resume fast growth; when a firm is distressed with excessive debt it goes into bankruptcy court and gets debt relief that allows it to resume investment, production and growth; when a household is financially distressed it also needs debt relief to be able to have more discretionary income to spend. So any unsustainable debt problem requires debt reduction. The lack of debt relief to the distressed households is the reason why this financial crisis is becoming more severe and the economic recession - with a sharp fall now in real consumption spending – now worsening. The fiscal actions taken so far (income relief to households via tax rebates) and bailouts of distressed financial institutions (Bear Stearns creditors’ bailout, Fannie and Freddie and AIG) do not resolve the fundamental debt problem for two reasons. First, you cannot grow yourself out of a debt problem: when debt to disposable income is too high increasing the denominator with tax rebates is ineffective and only temporary; i.e. you need to reduce the nominator (the debt). Second, rescuing distressed institutions without reducing the debt problem of the borrowers does not resolve the fundamental insolvency of the debtor that limits its ability to consume and spend and thus drags the economy into a more severe economic contraction.

So of the five possible uses of fiscal policy – income relief to households (the 2008 tax rebate), rescue/bailout of financial institutions (Bears Stearns, Fannie and Freddie, AIG), purchase of assets of failed institutions (an RTC-like institution), recapitalization of undercapitalized financial institutions (an RFC-like institution), government purchase of distressed mortgages to provide debt relief to households (an HOLC-like institution) – the last option is the most important and effective to resolve this severe financial and economic crisis. During the Great Depression the Home Owners’ Loan Corporation was create to buy mortgages from bank at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed rate mortgage rates. This massive program allowed millions of households to avoid losing their homes and ending up in foreclosure. The HOLC bought mortgages for two year and managed such assets for 18 year at a relatively low fiscal cost (as the assets were bought at a discount and reducing the face value of the mortgages allowed home owners to avoid defaulting on the refinanced mortgages). A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced; thus it will be the macro equivalent of the “bad bank” that Lehman tried to create for its bad assets.

Creating a new HOLC mechanism is likely to be more effective than creating a new RTC (whose purpose was to buy and dispose over a number of years of the assets of already failed S&Ls): we need to provide debt reduction to households well before hundreds of banks failed as working out the bad assets only after banks have failed is costly. Certainly many insolvent banks will fail regardless of in this financial crisis; and once they do their bad assets can be transferred to the new HOLC to be rapidly worked out. But we don’t need an RTC that picks up the bad assets of failed banks and works them out after such banks have failed; the priority is to take off the balance sheet of distressed and/or potentially insolvent banks the bad assets and reduce their face value so as to avoid a tsunami of defaults, foreclosures and/or households walking away from their homes. Similarly having an HOLC is more important than creating an RFC (the institution that during the Great Depression injected public capital – in the form of preferred shares – into 4000 undercapitalized banks).

It does not appear that either McCain or Obama have hit on this yet, although Obama comes closest with his recognition that the 2005 bankruptcy legislation needs to be reversed.

While most folks who try to be responsible with their money find the concept of bankruptcy to be odious, Roubini seems to have defined the concept of debt forgiveness as necessary in the greater economic scheme of things.