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How Mortgage Debt is Holding Back the Recovery

How Mortgage Debt is Holding Back the Recovery

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Published by: Roosevelt Institute on Jun 28, 2012
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Key Findings
Several years into this recession, the overall amount ofunderwater mortgage debt is still very high. Recentestimates show that a third of all houses with amortgage owe more than the home is worth, and thetotal amount of underwater mortgage debt could cometo $1.2 trillion.
The most recent empirical evidence, from academicquarters to the IMF, shows that underwater mortgagedebt is creating a drag on the economic recovery. Therecovery is weaker in places where mortgage debt is thehighest, as more mortgage debt results in lowerconsumption and higher unemployment.
Other explanations of the relationship between thehousing crash and the weak economy, such as structuralunemployment created by the house bubble, containserious weaknesses.
Debt writedowns, foreclosure mitigation, and otherhousing sector specific policies are a crucial tools indealing with this “balance-sheet recession” and ge
ingthe economy started again.
Foreclosures exacerbate these problems by creatingvicious cycles of destructive economic activity. Someestimate that foreclosures have caused an additional 25percent of the decline in economic activity.
The market is not likely to sort this out by itself. Thereare numerous conflicts within the system of servicersthat manage mortgage debt that incentivize saddlingconsumers with greater burdens.
MICHAEL KONCZAL
is a fellow with the RooseveltInstitute, where he works on financial reform,unemployment, inequality and a progressive vision ofthe economy. His blog, Rortybomb, was named one ofthe 25 Best Financial Blogs by
Time Magazine
. His workhas appeared at
The American Prospect
, Slate,
BostonReview 
,
Washington Monthly
,
Dissent
, the
Financial Times
, and
The Nation
.To contact the author, call 212.444.9140 or emailmkonczal@rooseveltinstitute.org.
 
How Mortgage Debt is Holding Back the Recovery
Mike Konczal | The Roosevelt Institute
LastUpdated: June 28, 2012
Background
The United States experienced a major housing bubble over the past 10 years. From 2006 to 2009, housingprices dropped 28 percent across the United States.
1
 This has led to a widespread collapse in the value ofassets for U.S. households. Estimates of the number ofhouseholds that owe more on their mortgages than theirhouses are worth range from 23 percent to 31 percent,while the total amount of underwater mortgage debtranges from $715 billion to $1.2 trillion.
2
 Unemployment has stayed stubbornly high in thea
ermath of a recession that started in December 2007and o
cially ended in March 2009. Peaking at 10percent in October 2009, unemployment still remainsabove 8 percent. There are still more than 12.5 millionunemployed people in the United States, up significantlyfrom the 7 million who were unemployed before therecession. Unemployment has fallen much more slowlythan originally projected, including projections by theFederal Reserve. The unemployment picture is evengrimmer when it includes discouraged workers who havegiven up looking for work – some estimates showunemployment approaching 9.6 percent.
3
The source of this slow growth and persistently highlevel of unemployment has been strongly debatedamong economists. Some believe it is the result ofstructural issues within the economy, the composition ofthe unemployed, or uncertainty resulting from theObama administration’s policies. Others believe it has todo with the nature of recessions that follow a financialcrisis, citing historical relationships between the two.
4
But a wave of research has recently found thatunemployment and slow growth are connected to thea
ermath of the housing bubble collapse as well as thedeleveraging resulting from dealing with bad debts. Thisresearch, which is o
en referred to as a “balance-sheetrecession” view of the economy, is quickly becomingvery important in discussions over the bad economy.This paper seeks to summarize this latest research. Asthis research is forming opinions at the IMF and theWhite House, it is important to be familiar with how itviews the economic slump.
Copyright 2012, the Roosevelt Institute. All rights reserved.WWW.ROOSEVELTINSTITUTE.ORG
The views and opinions expressed in this paper are those of the author and do not necessarily represent the views of the Roosevelt Institute, its o
 ffi
cers, or its directors.
1
 
Three Stories About The Relationship BetweenMortgage Debt and Unemployment
Figure 1 shows the relationship between underwaterhomes and the unemployment rate. The underwaterdata is taken from CoreLogic, and the unemploymentnumbers are from the Bureau of Labor Statistics. Thisrelationship remains consistent whether you look at thepercent that are underwater or the percent that aredeeply underwater. It also holds if you look atforeclosures versus unemployment, as foreclosures anddeeply underwater homes are tightly linked. As we shallsee, this relationship also holds more broadly. We seesimilar relationships between household debt and slowgrowth and high unemployment at the county level inthe United States. We also see this relationshipinternationally.There are three theories that try to explain thisrelationship. The first two have to do with structuralunemployment and with the wealth e
ff 
ects of a declinein housing values. The third theory is the balance-sheetrecession argument. This argument holds that the debtoverhang itself is driving the decline in demand, whichgenerates high levels of unemployment. This is thetheory that is supported by current research.
Structural Unemployment
The first theory that seeks to explain this relationship isthat it is evidence of “structural unemployment.” Usuallyeconomic writers are referring to one of two possiblescenarios in this situation. In the first, the economy’sability to match workers and jobs has broken down. Inparticular, it usually refers to a situation in which theunemployed are incapable of working the available jobs.A range of issues can cause this, from a lack ofgeographic mobility to the unemployed lackingnecessary skills. In the second, concerns about thegovernment’s impact on the economy, from deficits totax and regulatory policy, is what is holding back theeconomy.It does not appear that a lack of skills or otherworkforce related characteristics are keeping theunemployed from finding work. Unemployment is upacross all categories of industry and occupation. Quitrates are low and wage gains sluggish, which shows thatthe labor market is not strong for those currently with jobs. Employers are not showing an increased intensityin searching to fill new jobs. A recent Federal ReserveBank of Chicago research le
er found “limited evidenceof skills mismatch” in the United States’ labor market.
Copyright 2012, the Roosevelt Institute. All rights reserved.WWW.ROOSEVELTINSTITUTE.ORG
2
Figure 1:
!"#"$"%"&"'!"'#"'$"'%"!(!!)"'!(!!)"#!(!!)"*!(!!)"$!(!!)"+!(!!)"%!(!!)",!(!!)"
   U  n  e  m  p    l  o  y  m  e  n   t   R  a   t  e ,   A  v  e  r  a  g  e   2   0   1   1
Percent of Mortgages that are Underwater Q2 2011 (CoreLogic)
The Relationship Between Underwater Mortgages and Unemployment
 
Crucially, there’s li
le evidence that underwatermortgages are slowing moving and mobility rates - ifanything there is some evidence that mobility might behigher in states with more underwater mortgages.Underwater mortgages are not slowing the labor marketby keeping people from moving. Though there are nodoubt some regions and some people who are a
ff 
ectedby this phenomenon, we do not see a large enoughincrease in vacant job openings to justify this as anargument overall.
5
Negative Wealth E 
 ff 
ect
There's a second theory that a
ributes the above graphto a "wealth e
ff 
ect." In this theory, as housing pricesrose, people spent more because they felt wealthier.When housing values collapsed, people felt poorer, sothey spent less. But the latest Economic Report of thePresident argued that the "severity of lossesexperienced during the recession that began inDecember of 2007 in both national output and in labormarkets makes these [wealth e
ff 
ect] estimates appeartoo small." Households are spending significantly lessthan what is implied from the fall in value of housing.Households are both the net seller and the net buyer ofhousing. So although some people who intend to selltheir homes in the short-term will experience a declinein the wealth e
ff 
ect as a result of the housing crash, it iso
ff 
set by other households, like renters, who now canpurchase more housing than they could before. It isn’tclear that this should have an impact across the countryas a whole.
6
Recent research which will be discussed in the nextsection, Mian and Sufi’s “Household Balance Sheets,Consumption, and the Economic Slump,” finds that thewealth e
ff 
ect would have to be significantly higher thanany reasonable previous estimate to account for thedecline in spending we’ve seen in this recession. Theelasticities, or the quantified measure of the wealthe
ff 
ect, would have to be “on the order of 0.3 to 0.5 fornon-durable goods and 0.5 to 0.7 for durable goods.Previous research suggests an elasticity of consumptionwith respect to housing wealth of 0.05 to 0.10.”They also find that households with fewer financialsavings and assets had a much larger decrease inconsumption, controlling for household prices. Thismeans a decline in spending isn’t just related tohousehold values, but more largely to debt.
Balance Sheet Recession
There’s a third theory that explains the relationshipbetween the housing crisis, underwater mortgages, andmass unemployment. It is o
en referred to as a“balance-sheet recession.”Under this theory, households look to maintain a certainleverage ratio, or a certain ratio of debt to income. Ahousehold balance sheet, like any balance sheet, hastwo sides: assets and liabilities. As housing valuesincreased, people borrowed against those increases.This means that liabilities also increased in the form ofmore mortgage debt.
7
A balance-sheet recession requires three conditions: (i)su
cient inequality so that creditors and debtors aretwo distinct groups, (ii) a negative shock to the assets ofthe debtors so that debtors start to pay down debtsquickly in the form of deleveraging , and (iii) the inabilityof creditors to make up the di
ff 
erence in consumption,an inability usually triggered by a “zero lower bounds”on monetary policy.When it comes to condition (i), household debt doubledfrom $7 trillion to $14 trillion from 2001 to 2007.Meanwhile, debt-to-GDP went from 0.7 to 1.0 over thesame period. This increase in debt was mostly related tothe housing bubble. Holding income constant, researchfinds that the rise in debt was due to householdsborrowing against increased housing prices.
8
Assets also increased during this time period. Housingvalues experienced double-digit yearly growth from2003 to 2005, with a 15 percent national increase in2005 alone. Thus the rise in mortgage debt wasbalanced by a rise in housing values. However, startingin 2006, housing values peaked and then began to crash.
9
For the purposes of condition (ii), this le
householdbalance sheets distorted, with households carrying farmore debt as a portion of their assets.The balance-sheet recession theory argues that asconsumers’ balance sheets shi
to having far more debtthan assets as a result of the collapse in housing prices,they will cut back on consumption until their householdbalance sheets are “repaired.” Precautionary savings willincrease household savings even further, which canfurther hinder the potential output of the economy. Ashock to the net worth of debtors, who previously had ahigh propensity to consume, can lead to a decline ineconomic activity. We can see this deleveraging byexamining the Federal Reserve’s Flow of Funds data, inFigure 2, which shows the quarterly percentage ingrowth of credit by sector. This is even more remarkable
Copyright 2012, the Roosevelt Institute. All rights reserved.WWW.ROOSEVELTINSTITUTE.ORG
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