The federal government spent countless billions during the Great Recession to help troubled homeowners avoid foreclosure, and the results were, at best, mixed. But what if mortgages themselves came with built-in protection, an “automatic stabilizer” that would reduce a borrower’s interest rate during a recession? What if that protection cost little or nothing for banks or taxpayers to provide?
Two economists, Arvind Krishnamurthy at Stanford Graduate School of Business and Janice Eberly at Northwestern’s Kellogg School of Management, outline exactly that kind of idea and argue it could be a win for all sides — banks, homeowners and the economy as a whole.
Both economists have deep experience in the field. Krishnamurthy is a leading analyst of the Federal Reserve’s rescue efforts, which included buying up trillions of dollars in mortgage-backed securities. Eberly, who served as assistant secretary of the Treasury for economic policy from 2011 to 2013, led efforts to retool the Obama administration’s foreclosure-prevention programs.
In their new paper for the Brookings Papers on Economic Activity, the two develop a framework for analyzing alternative strategies for helping homeowners if a similar crisis arises in the future. One key idea: an automatic mortgage stabilizer that would become a standard feature of any home loan.
One raging debate during the mortgage meltdown was whether the government should reduce the principal amounts that homeowners owed on their mortgages. Advocates of debt reduction argued that it was crucial to prevent a wave of “strategic defaults” by underwater borrowers — those whose homes had fallen in value to less than their unpaid mortgage.
Krishnamurthy and Eberly disagree. Many troubled borrowers, even those who are underwater, will go to great lengths to avoid losing their homes. The bigger problem is that millions of people simply can’t keep up with their payments during a recession. They also have to cut back on all other spending, which only adds to the economic downturn.
“What you want to do is create the maximum amount of relief upfront, during the crisis,” Krishnamurthy says. “Reducing principal is helpful, but the benefits are spread over the life of the mortgage. It doesn’t do much to boost consumption and reduce defaults during the crisis.”
By driving interest rates down to almost record lows, the Federal Reserve did indeed help many homeowners reduce their monthly payments. But most distressed borrowers weren’t able to refinance, at least not without government help, because their incomes and creditworthiness had fallen and banks had drastically tightened lending standards. Those whose loans were underwater could not get a new one for an equivalent amount because it would exceed the value of the home.
“The Fed’s monetary policies couldn’t target distressed households,” Krishnamurthy says.
The proposed automatic stabilizer could be a standard feature of every new mortgage. In effect, it’s a provision that would automatically let a borrower reset their mortgage at a lower interest rate during a recession.
A Stabilizer May Actually Reduce Costs for Banks
The lower rate wouldn’t have to be subsidized by either the bank or the government, because interest rates almost always decline in a recession anyway. Indeed, millions of homeowners whose finances were still solid enough to get a new mortgage did in fact reduce their monthly payments by hundreds of dollars.
The new stabilizer would provide that same opportunity to distressed homeowners, even if they are underwater and unable to get a new mortgage at a lower rate. “It’s essentially an automatic refinancing, and it’s much cheaper and easier than going through the whole process of getting a new mortgage,” Krishnamurthy says. It might seem that this kind of protection would add to the cost of a standard mortgage. After all, a lender loses revenue when it reduces the interest rate its borrowers have to pay.
But Krishnamurthy says that doesn’t have to be the case. In fact, he says, it is possible that the automatic stabilizer would actually reduce a bank’s cost.The key reason is that investors in mortgages already price in the risk of lower rates. Banks and institutional investors know that many borrowers will refinance if interest rates drop significantly, so they already factor that potential cost into the price of a mortgage.
On top of that, Krishnamurthy says, the automatic stabilizer may actually reduce a bank’s cost by reducing the risk of default during bad times. “It could be a win-win,” he says. “The big advantage of this proposal is that it is very close to what banks are already doing. It wouldn’t be a radical change.”
Krishnamurthy and Eberly are not saying that an automatic stabilizer mortgage would resolve a crisis on its own. In a severe meltdown like the last one, the government may still have to prop up homeowners and the economy with taxpayer money. The main purpose of their paper is to identify the most effective way to deploy those scarce public resources when that kind of crisis arrives. Nevertheless, their proposal offers a creative new tool that could ease the next crisis before the government has to step in.
Arvind Krishnamurthy is a professor of finance at Stanford Graduate School of Business. Janice Eberly is the James R. and Helen D. Russell Professor of Finance at the Kellogg School of Management at Northwestern University. “Efficient Credit Policies in a Housing Debt Crisis” was published in the Fall 2014 issue of Brookings Papers on Economic Activity.