By Carolyn Sissoko, who has a PhD in economics from UCLA and a JD from the University of Southern California. She is an independent researcher who writes on financial regulation, the history of banking, and monetary theory. Originally published at Synthetic Assets
Please find the Sissoko’s first post on HAMP, principal reduction and financialization here. For the introductory post see here.
The series is motivated by Peter Ganong and Pascal Noel’s argument that mortgage modifications that include principal reduction have no significant effect on either default or consumption for underwater borrowers. In post 1 I explained how the framing of their paper focuses entirely on the short-run, as if the long run doesn’t matter – and even uses language that indicates that people who take their long-run financial condition into account are behaving improperly. I call this exclusive focus on the short-run the ideology of financialization. I note at the end of post 1 that this ideology appears to have influenced both Geithner’s views and the structure of HAMP.
So this raises the question: What’s the problem with the ideology of financialization?
The short answer is that it appears to be designed to trap as many people into a state of debt peonage as possible. Debt peonage, by preventing people who are trapped in debt from realizing their full potential, is harmful to economic performance more generally.
Here’s the long answer.
By focusing attention on short-term payments and how sustainable they are today, while at the same time heaping heavy debt obligations into the future, modern finance has had devastating effects at both the individual and the aggregate levels. Heavy long-term debt burdens are guaranteed to be a problem for a subset of individual borrowers, such as those who are unexpectedly disabled or who see their income decline over time for other reasons. Mortgages with payments that balloon at some date in the future (such as those studied in Ganong and Noel’s paper) are by definition a gamble on future financial circumstances. This makes them entirely appropriate products for the small subset of borrowers who have the financial resources to deal with the worst case scenario, but the financial equivalent of Russian roulette for the majority of borrowers who don’t have financial backup in the worst case scenario. (Remember the probabilities are in your favor in Russian roulette, too.)
Gary Gorton once described the subprime mortgage model as one where the borrower is forced to refinance after a few years and this gives the bank the option every few years of whether or not to foreclose on the home. Because the mortgage borrower is in the position of having sold an option, the borrower’s position is closer to that of a renter than of homeowner. Mortgages that are structured to have payment increases a few years into the loan – which is the case for virtually all of the modifications offered to borrowers during the crisis – similarly tend to put the borrower into a situation more like that of a renter than a homeowner.
The ideology of financialization thus perverts the whole concept of debt. A debt contract is not a zero-sum transaction. Debt contracts exist because they are mutually beneficial and they should be designed to give benefits to both lenders and borrowers. Loans like subprime mortgages are literally designed to set the borrower up so the borrower will be forced into a renegotiation where the borrower can be held to his or her reservation value. That is, they are designed to shift the bargaining power in contracting in favor of the lender. HAMP modifications for underwater borrowers set up a similar situation.
Ganong and Noel treat this distorted bargaining situation as if it is normal in section 6 of their paper, where they purport to characterize “efficient modification design.” The first step in their analysis is to hold the borrowers who need modifications to their reservation values (p. 27).[1] Having done this, they then describe an “efficient frontier” that minimizes costs to lenders and taxpayers. A few decades ago when I studied Pareto efficiency, the characterization of the efficient frontier required shifting the planner’s weights on all members of the economy. What the authors have in fact presented is the constrainedefficient frontier where the borrowers are held to their reservation values. Standard economic analysis indicates that starting from any point on this constrained efficient frontier, direct transfers from the lenders to the borrowers up until the point that the lenders are held to their reservation value should also be considered part of the efficient frontier.
In short, Ganong and Noel’s analysis is best viewed as a description of how the financial industry views and treats underwater borrowers, not as a description of policies that are objectively “efficient.” Indeed, when they “rank modification steps by their cost-effectiveness” they come very close to reproducing the HAMP waterfall (p. 31): the only difference is that maturity extension takes place before a temporary interest rate reduction. Perhaps the authors are providing valuable insight into how the HAMP waterfall was developed.
The unbalanced bargaining situation over contract terms that is presented in this paper should be viewed as a problem for the economy as a whole. As everybody realized post-crisis the macroeconomics of debt has not been fully explored by the economics profession and the profession is still in the early stages of addressing this lacuna. Thus, it is not surprising that this paper touches only very briefly on the macroeconomics of mortgage modification.
In my view the ideology of financialization with its short term focus has contributed significantly to growth of a heavily indebted economy. This burden of debt tends to reduce the bargaining power of the debtors and to interfere with their ability to realize their full potential in the economy. Arguably this heavily indebted economy is losing the capacity to grow because it is in a permanent balance sheet recession. At the same time, the ideology underlying financialization appears to be effectively a gamble that it’s okay to shift the debt off into the future, because we will grow out of it so it will not weigh heavily on the future. The risk is that, by taking it as given that g > r over the long run, this ideology may well be creating a situation of permanent balance sheet recession where g is necessarily less than r, even given optimal monetary policy.
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[1] The authors justify this because they have “shown” that principal reductions for underwater borrowers do not reduce defaults or increase consumption. Of course, they have shown no such thing because they have only evaluated 5-10% of the life of the mortgage – and even that analysis is flawed.
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It continues to amaze me how poor a job the economics profession does in understanding balance sheet realities. That the Fed continued for so long to “stimulate” the economy with low interest rates, while households piled up debt and were encouraged to dis-save–storing up massive problems due to an inability to retire securely–must be laid at the feet of boneheaded economists. I am a recovering PhD economist (now a financial planner) and I am very, very worried.
It is hard to make a person understand something when their paycheck depends on them not understanding it.
It is not fair to call them boneheaded, when they seem to do pretty well as court fluffers for the oligarchs.
Of course, the piled on debt phenomenon is not limited to only sub-prime homeowners.
The leveraged financial math also applies to companies that are acquired by private equity firms (AKA leveraged buyout firms), as these firms are converted to sub-prime corporate borrowers.
Years ago, private equity firms would promote the value of converting corporate equity into corporate debt via LBOs as focusing lazy management on running their businesses more efficiently to meet the interest payments.
At least I have not heard economists calculate and promote the excess value to the USA economy of workers with additional “motivation” caused by a heavy personal debt-load.
Few economists worry about debt and debt structure. M. Pettis talks about whole economies with “inverted balance sheets”
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I think this applies to subprime lending. It is pro-cyclical and comes late in the cycle. You have just been paying interest on your mortgage when the Fed starts rising rates to cool the economy, then comes the recession when the probability of an adverse shock increases just when you should start paying (increasing) interests and principal —-> default, default,default!
Few economists worry about debt and debt structure. M. Pettis talks about whole economies with “inverted balance sheets”
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I think this applies to subprime lending. It is pro-cyclical and comes late in the cycle. You have just been paying interest on your mortgage when the Fed starts rising rates to cool the economy, then comes the recession when the probability of an adverse shock increases just when you should start paying (increasing) interests and principal —-> default, default,default!
Thanks for this clear and concise series that exposes the real economy and the shell game that was the “recovery”. I’m looking forward to the third installment
> Arguably this heavily indebted economy is losing the capacity to grow because it is in a permanent balance sheet recession. At the same time, the ideology underlying financialization appears to be effectively a gamble that it’s okay to shift the debt off into the future, because we will grow out of it so it will not weigh heavily on the future.
Two points. Groaf is killing the future on a physical level, and Michael Hudson has explained over and over that debt grows faster than the economy and therefore it is impossible to “grow out of it”.
Hmmm, what to do? Tax the crap out of the filthy rich to pay for a lot of people to do nothing, an inverse jawb guarantee of sorts, and a debt jubilee with the goal of never accumulating debt again.
Think of how you could erect a middle finger to the system if you weren’t drowning in debt. You wouldn’t have to insanely thrash and use gargantuan amounts of energy to keep the debt monster that’s now biting your ass from eating you alive.
I mentioned the other day that I’ve never had a credit card, am averse to debt and profoundly distrust financial(and other) institutions.
someone wondered why…and how i manage to exist in this country.
well…this is why,lol.
although, whether being debt free allows one to better “erect a middle finger”…the jury is still out on that one.
unindebtedness contains it’s own limitations, and the only Rights one really has are those one can enforce.
The broader sweep of the article(and it’s other parts), regarding the almost enforced indebtedness of our modern economy, makes me glad I never caught that particular addiction.
Oh, trust me…I would love to not have a credit card at all if I could get away with it. The problem is that where I live it is almost impossible to find even a crappy apartment if your FICO score is lower than 600. Also, when I bought a used car two years ago, I would never have been approved for the auto loan if it was less than mine currently is. I live twenty minutes northeast of Rochester, Minnesota where there is no public transportation so I have no choice but to have a car.
It is amazing how a rather arbitrary number like one’s credit score determines so many seemingly unrelated things. It is even more ridiculous when credit checks are a part of the hiring process for many employers even for crappy retail or fast food jobs when it is low wages that have been a large driver of debt for many people in the first place.
I know that many states are considering making it illegal to base hiring decisions on credit history, but it would be hard to enforce for the same reason that illegal job discrimination in other protected classes is hard to enforce. At will-employment allows an employer to make up practically any reason on the fly or no reason at all as to why you were not hired and good luck getting any details at all from a potential employer as to why you were turned down for a job.
The way things are going, poverty is becoming a criminal offense…the ultimate self-defeating strategy for the overlords of finance.
The older I get the more shocking becomes the essential unfairness of our system. I am trying to figure out whether it’s getting worse or I just didn’t see it clearly before. Thinking it’s probably a combination of both.
Interesting story in the NYT today about young evangelicals. Reminds me that Jesus was a radical in all the best ways. How sad that his message has been coopted by a party that stands for the opposite.
so far, my car insurance is cheap(touch wood), likely due to location(and lack of tickets).
that’s a worry, if they get crazier about credit scores. I’ve noticed that the premiums dont go down,lol..
my other big worry along these lines(criminalising poverty…and even criminalising not playing the game) is if we go cashless.
But I can’t think how they’d get away with that, at least yet…and at least in Texas.
There are very, very few places I know of, or have been…even in the big cities…where the wave your fone payment method is the norm.
But I admit that I may have just missed it…and i may have missed the acceptability of cashless payments(don’t know enough young adults)
I have noted that in all the stores i’ve been in that have the self-checkout…nobody uses them, even if the store is trying to force the issue by having few humans checking.
My main financial focus for 25 years has been keeping our little place unencumbered and free-and-clear.
No mortgage, no use as collateral. Period.
This one of my only successes in influencing my mother’s behaviour.
Not to mention how useless or downright destructive many of the ‘jobs’ are.
I recall a chat I had with a member of congress around the 2007/8 financial crisis and subsequent bail out of the institutions which blew themselves up and were basically insolvent. I asked, why not take tax payer dollars, funnel them to home owning tax payers with the condition that they use the funds to pay down/off their mortgages to the banks. The banks get new resources, tax payers have less debt, and more future income can be spent in new consumption, boosting demand which might create enough incentive for businesses to create jobs. After all, businesses seeing declining demand for their products won’t borrow money for the business no matter how cheap it is. The member of congress said the government should not give people money, even when it is their own money. I said, so you think it is OK for the government to give the banks tax payer money to keep them afloat after making, buying or guaranteeing bad loans, and still allowing the banks to also get repaid in full by tax payers. In a sense, paying the banks twice? He knew he was wrong, just not human enough to admit it.
Wall Street has too much money to lend => More money is available for mortgages => House prices rise to a point where they are not affordable with sane, amortizing mortgages.
Thanks for this post.
In post 1 I explained how the framing of their paper focuses entirely on the short-run, as if the long run doesn’t matter – and even uses language that indicates that people who take their long-run financial condition into account are behaving improperly. I call this exclusive focus on the short-run the ideology of financialization.
I’ll make an analogy: Hunting season is coming around again – Nov. quail, pheasant, deer, and later goose and duck hunting seasons’ open. In the 19th and early 20th C there were no limits on how many birds or deer or buffalo a hunter or hunters could take, or which sex (m/f), or what seasons or what daily hours were open for hunting. In due course, hunters hunted the passenger pigeon to extinction*, and nearly wiped out the buffalo**. Imagine that unregulated hunter/prey arrangement as the same kind of short-term thinking as the modern short-term finanialized thinking.
After the passenger pigeons were gone people realized game animal populations weren’t infinite; there had to be limits on hunting in order to have game populations survive into the future, year after year.
Somehow the idea that unlimited and unregulated “hunting” for borrowers for profits today will wipe-out the future pools of financially capable borrowers for mortgage or other financial predators never crosses their minds, imo. The idea that a population of borrowers as borrowers can be driven to “extinction” (can’t borrow any more in future, no matter the term) never occurs to these financializing “geniuses”.
*passenger pigeon:https://en.wikipedia.org/wiki/Passenger_pigeon
**buffalo:https://en.wikipedia.org/wiki/Bison_hunting
Well, you know, it wasn’t just sport hunters. It was commercial hunting that did the passenger pigeons in, they were slave food. That’s a whole ‘nother kettle of fish.
Every time I hear an “expert” say ‘the market is self regulating’ I think of passenger pigeons. The ‘market’ is insatiable; it is not self regulating.
“…the ideology of financialization with its short term focus has contributed significantly to growth of a heavily indebted economy. This burden of debt tends to reduce the bargaining power of the debtors…”
A feature not a bug.
I would like to see usury laws put back in place. I would like to see all executive bankers’ salaries to be capped at the average net wage. There should be specific rules against inequality. All billionaires should be taxed 90%. All offshore havens should be closed, and I, of course, am just daydreaming.
Japan shows how long it can take an indebted economy to recover.
They had their debt fuelled boom in the 1980s and are still suffering the consequences.
Richard Koo has had nigh on thirty years to study Japan’s balance sheet recession.
https://www.youtube.com/watch?v=8YTyJzmiHGk
The fact we fail to grasp is that bank loans spent today, impoverish the future in which the repayments are made.
The central banks started revealing how banks really work, and where money comes from, starting with the BoE in 2014.
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf
Banks create money from loans.
When you know this you can see how bank credit works; it effectively lets you borrow your own money from the future to spend today.
You can create a real estate boom today, and impoverish the next 20 – 30 years as they did in Japan. You spend the money on over-priced real estate today, and pay for it over the 20 – 30 years. When most of a nation does this, you have a really impoverished future with an economy threatening to spiral into debt deflation.
1920s – Debt fuelled boom
1930s – The debt deflation of the Great Depression
The roaring 20s, roared on money borrowed from the 1930s, when the repayments were being made.
Closes, but here is what I think.
Banks create money from earnings.
Secured loans are created from past earnings. (Money earned was spent on an asset now used as collateral.)
Unsecured loans are created from future earnings.
In both cases the banks hope to be paid back from future earnings.
For the rest of your statement I think you are spot on.