JANICE EBERLY Northwestern University ARVIND KRISHNAMURTHY Stanford University Efficient Credit Policies in a Housing Debt Crisis ABSTRACT Consumption, income, and home prices fell simultaneously during the financial crisis, compounding recessionary conditions with liquidity constraints and mortgage distress. We develop a framework to guide govern- ment policy in response to crises in cases when government may intervene to support distressed mortgages. Our results emphasize three aspects of efficient mortgage modifications. First, when households are constrained in their bor- rowing, government resources should support household liquidity up-front. This implies modifying loans to reduce payments during the crisis rather than reducing payments over the life of the mortgage contract, such as via debt reduction. Second, while governments will not find it efficient to directly write down the debt of borrowers, in many cases it will be in the best interest of lenders to do so, because reducing debt is an effective way to reduce strategic default. Moreover, the lenders who bear the credit default risk have a direct incentive to partially write down debt and avoid a full loan loss due to default. Finally, a well-designed mortgage contract should take these considerations into account, reducing payments during recessions and reducing debt when home prices fall. We propose an automatic stabilizer mortgage contract which does both by converting mortgages into lower-rate adjustable-rate mortgages when interest rates fall during a downturn—reducing payments and lowering the present value of borrowers’ debt. uring the financial crisis and in its aftermath, those segments of the Deconomy most exposed to the accumulation of mortgage debt have tended to fare the worst. Whether one measures the impact by industry (construction), by geography (sand states), or by household (the most indebted), the presence of greater mortgage debt has led to weaker economic 73 74 Brookings Papers on Economic Activity, Fall 2014 outcomes (see, for example, Mian and Sufi 2009 and Dynan 2012). More- over, research suggests that financial crises may be more severe or may be associated with slower recoveries when accompanied by a housing col- lapse (Reinhart and Rogoff 2009; Howard, Martin, and Wilson 2011; and International Monetary Fund 2012). These observations lead to an apparently natural macroeconomic policy prescription: restoring stronger economic growth requires reducing accu- mulated mortgage debt. In this paper, we consider this proposal in an envi- ronment where debt is indeed potentially damaging to the macroeconomy and where the government and private sector have a range of possible policy interventions. We show that while debt reduction can support eco- nomic recovery, other interventions can be more efficient. We also show that whether debt reduction is financed by the government or by lenders matters for both its efficacy and its desirability. Hence, while the intuitive appeal of debt reduction is clear, its policy efficiency is not always clear, and the argument is more nuanced than the simple intuition. Our results emphasize three aspects of efficient mortgage modifications. First, when households are borrowing-constrained, government support should provide liquidity up-front. This implies loan modifications that reduce payments during the crisis, rather than using government resources for debt reduction that reduces payments over the life of the mortgage con- tract. The reasoning behind this result is simple and robust. Consider choos- ing among a class of government support programs, all of which transfer resources to a borrower, but which may vary in the timing of transfers. Sup- pose the objective of the program is to increase the current consumption of the borrower. For a permanent-income household, only the present dis- counted value of the government transfers matters for current consumption. But for a liquidity-constrained household, for any given present discounted value of transfers, programs that front-load transfers increase consumption by strictly more. Thus, up-front payment reduction is a more efficient use of government resources than debt reduction. Second, while governments will not find it efficient to directly write down borrower debt, in many cases it will be in the best interest of lenders to do so. Reducing debt is effective in reducing strategic default. Lend- ers, who bear the credit default risk, have a direct incentive to partially write down debt and avoid greater loan losses due to default. In cases where there are externalities from default that will not be internalized by the lender, government policy can be effective in providing incentives or systematic structures to lenders to write down debt. Finally, a well-designed mortgage contract should take these considerations into account ex ante, JANICE EBERLY and ARVIND KRISHNAMURTHY 75 reducing payments during recessions and reducing debt when home prices fall. We propose an automatic stabilizer mortgage contract which does both by converting mortgages into lower-rate adjustable-rate mortgages when interest rates fall during a downturn—reducing payments and lowering the value of borrowers’ debt. We begin with a simple environment with homeowners, lenders, and a government. We start from the simplest case, namely one with perfect information where all households are liquidity constrained. We then layer on default, private information, heterogeneous default costs, endogenous provision of private mortgage modifications by lenders, and an equilibrium home price response. Initially, homeowners may consider defaulting on their mortgages because they are liquidity constrained (that is, cash-flow constrained) or because their mortgages exceed the value of their homes (strategic default), or because both considerations may be present. The government has finite resources and maximizes utility in the planner’s problem. We initially consider a two-period model with exogenous home prices and then allow for general equilibrium feedback. We ask, “What type of intervention is most effective, taking into account the government budget constraint and the program’s effectiveness at supporting the economy?” We consider a general class of interventions that includes mortgage modifications, such as interest rate reductions, payment deferral, and term extensions, as well as mortgage refinancing and debt write-downs. We extend the model to include default with known, uncertain, and unobserved default costs, with dynamic default timing, and with lender renegotiation. The model is abstract and simple by design, allowing us to focus on the minimum features necessary to highlight these mechanisms in the hous- ing market. It omits many interesting and potentially relevant features of the housing market and of the economy more generally. For example, we generate a “crisis period” exogenously by specifying lower income in one period to disrupt consumption smoothing by households. We could, in principle, embed our housing model in a general equilibrium frame- work that would derive lower income and generate the scope for housing policy endogenously, as in the studies done by Gauti Eggertson and Paul Krugman (2010), Robert Hall (2010), Veronica Guerrieri and Guido Lorenzoni (2011), Emmanuel Farhi and Ivan Werning (2013), and others. For example, in the work by Eggertson and Krugman, the nominal values of debt and sticky prices, along with the liquidity-constrained households that we include, cause output to be determined by demand; hence there is scope for policy to improve macroeconomic outcomes when the debt constraint 76 Brookings Papers on Economic Activity, Fall 2014 binds and the nominal interest rate is zero. Including our model in such a structure would also allow us to examine how housing policy feeds back into the macroeconomy from the housing market. While this would be an interesting route to pursue, our focus is on distinguishing between various types of housing market interventions, so the additional impact that may come from the macroeconomic feedback is left for further work. Here the crisis period is defined by low income, which constrains con- sumption due to liquidity constraints. The household cannot borrow against future income nor against housing equity in order to smooth through the crisis. The government has a range of possible policy interventions and a limited budget; we focus on policies related to housing modifications, given the severity of the constraints and defaults experienced there. For simplicity, we begin with a case without default. The main result that comes from analyzing this case is that the need for consumption smoothing favors transfers to liquidity-constrained households during the crisis period. Optimally, such transfers will take the form of a payment deferral, granting resources to the borrower in a crisis period in return for repayment from the borrower in a noncrisis period. We then add the potential for default and show that optimal policies that concentrate transfers early in the crisis but require repayment later may lead to defaults. These results suggest that payment deferral policies alone (which grant short-term reductions in home payments but are repaid with higher loan balances later), may generate payments that rise too quickly and gener- ate defaults, suggesting that payment forgiveness to replace or augment payment deferrals may be optimal. That is, government resources should first be spent on payment forgiveness. Once the resource