A Common Sense approach to tackling the current Economic Crisis

In what is rightly characterized as the worse economic situation since the Great Depression, I have been wondering why despite all the advancement in economic theory and research and easy availability of data, we have not yet found the solution. We have had the monetary authorities using both conventional and unconventional methods and governments using fiscal stimulus in the form of tax breaks, spending and subsidies but growth continues to elude. I do not claim to be an economist or having any deep understanding of the economic theory but based on a lot of thinking, I have been drawn into believing that this is a classic case of too much intelligence taking over common sense.

The current economic crisis began with a housing crash that continues to weigh down on the economy. US households hold most of their tangible net worth in the form of home equity and with falling home prices, their net worth continues to fall. There are millions of homeowners who have negative equity on their homes and combined with declining real term wages and unprecedented high levels of unemployment, it is no surprise that delinquency rates continue to be high - 9% of mortgage borrowers are behind their payments and 4.6% of homes are in foreclosure. Falling net worth, increasing negative equity, foreclosures and people falling behind their mortgages dents consumer confidence across the spectrum and creates a vicious cycle. People who have money wait for the prices to fall further, banks weighed down by foreclosures and fears of ever increasing provisions put breaks on lending, and those falling behind payments have to cut down spending to make up or give up their homes and move into rental housing which further erodes their confidence. Foreclosures further increase the supply of unsold houses in the marker and fire sales further depress home prices. For any economic recovery to take place, this vicious cycle needs to be broken.

US households' mortgage debt averaged 10.3 trillion during the first quarter of 2011. While there is a general trend towards de-leveraging, the speed of de-leveraging has been far slower than the pace of leverage build-up during the bubble years due to tough economic conditions. Borrowers took on 1 trillion in new principal and 90 billion in extra interest in 2006 alone while mortgage debt has reduced by only 0.7 trillion in last 3 years from the 2008 peak. American consumers have finally learned that existing level of debt is unsustainable and they need to de-leverage. Tough economic conditions however have made that process painfully slow. Therefore a reduction in mortgage debt, adjustment in tenor and refinancing at lower rates can work wonders for both the American consumers and the Banks.

American government has announced total fiscal stimulus of aprx 1100 billion. Last stimulus of 700 billion created or saved 400,000 jobs and was therefore extremely expensive and the recently announced 400 billion stimulus is going to do nothing spectacular as well. Imagine if that 1100 billion was directed towards giving a one time debt waiver to homeowners chronically behind on their commitments and deep into negative equity. Even if one was to invoke the fairness principle and say the waiver need to be given to all, we are talking about roughly 10% of the mortgage debt disappearing from the system leading to interest savings of aprx 60 billion going straight into consumers pockets and an instant reduction in foreclosures and delinquent mortgages. Average cost of existing mortgages currently is 5.96% while a new 30 year mortgage can be negotiated at around 4.5%. If the government was to work with the banks to refinance all or bulk of the mortgages at the reduced rates, we are talking about a further 50-60 billion savings directly into the pockets of consumers and a further reduction in foreclosures.

More than the direct effects, such a process has enormous indirect benefits - people able to stay in their homes and interest savings translating into confidence build up and banks saving foreclosure costs and reduction in provisions for bad loans. Declining foreclosures would lead to stability in home prices as well.

It looks like a good and simple solution to me to tackle the main problem. There is however one problem with this, that of Moral Hazard. Waives are like entitlements - once you put them out, people start taking them for granted. This moral hazard has the potential of making the irresponsible American consumer more irresponsible. I don't think this problem can be tackled with certainty but it surely can be eliminated by effective regulation of the mortgage market from a prospective basis. Simple rules like a maximum 75% loan to value ratio, no complicated ballooning structures, prudent rating of mortgage securities and higher allocation of capital for high LTV mortgages can ensure we don't see the same levels of irresponsible lending. If the government can ensure effective regulation, then I would reckon this is a risk worth taking given that nothing else seem to be working.