This evening’s Prime Time featured the mortgage debt forgiveness/resolution debate, with a prominent contribution from our own Greg Connor. You can view it here.
Author: John McHale
At the risk of setting up Seamus for apoplectic rage in comments, he nicely gathers together much of the recent good news on the Irish economy in an article for the Evening Echo. The text of the article can be accessed via his excellent Economic Incentives website here. We still face serious challenges, as Seamus clearly notes, but it is no harm to accentuate the positive every now and then.
The Sunday newspapers certainly show the debate about mortgage debt forgiveness is gathering steam. Although policy in this area reflects a complex balancing of social and economic factors, an unavoidable aspect is the potential trade off between costs of any additional induced bank losses and the benefits debt forgiveness.
Just two quick (related) points. First, central to the argument for debt forgiveness is that banks have already made provisions for substantial mortgage debt-related losses. I don’t think Greg Connor’s point in an earlier thread about the weak connection between existing accounting-determined write-downs and the case for forgiving debt has received the attention it deserves.
This mixing up of accounting loss appraisal and debt forgiveness confuses an honest attempt to guess at likely losses (loss appraisal) with a completely separate activity which is trying to recover as much as is reasonably possible (debt management). Mixing up these two activities in this way would destroy the objectivity of bank accounting standards. It goes against every principle of accounting objectivity if accountants giving an honest appraisal of likely losses generate a change in bank cash flows. How could a bank accounting system by expected to be objective about loss appraisal in that case? Very bad notion.
Second, the concept of the debt Laffer curve is a useful tool for thinking about the potential trade off. If we are to the right of the peak of the curve, so that reducing the debt actually increases the expected value of repayment, then the case for forgiveness is strong – indeed banks would not need much prompting. This is most likely to be the case where banks would suffer large losses if borrowers walk away or if the bank pursues repossession. The current regime of impossible bankruptcy/full recourse/extensive forbearance would appear to make it unlikely we are to the right of the peak. I would be interested in people’s views.
While perhaps it is just an August effect, the broad quality of the analysis of European crisis-resolution efforts has been disappointingly poor, with a message the often does not go much beyond self-satisfying statements about the stupidity of European policy makers.
To make sense of more recent developments, I think it is critical to go back to the previous Franco-German summit at Deauville in October. The Deauville accord put in place plans for the permanent bailout mechanism to replace the EFSF in 2013. Understandably, debt restructuring was envisioned for countries needing new programmes under the ESM to limit both contingent liabilities and moral hazard. Unfortunately, however, this attempted strengthening of market discipline proved devastating for the creditworthiness of countries where any doubts existed about their ability to stabilise debt levels. Ireland can be seen as the first casualty, first getting sucked in and then actually seeing its bond yields rise steadily as the extent of default risk under the new arrangements became more evident. The ambivalence about default among key Irish opinion makers did not help. We then saw Portugal get sucked in as doubts emerged that it too might get sucked into the “black hole” of an EU/IMF programme given the limited nature of the exit options. The realisation that the structures that had been put in place were effectively a machine for self-fulfilling debt crises really came home as the creditworthiness of Italy and Spain began to ebb away.
The July 21 summit was a welcome attempt to move away from this “market discipline” regime. Although you would hardly know it from the commentary, and recognising there is a long way to go, the summit has been highly successful from an Irish perspective. The combination of the interest rate reduction, lengthened maturities and a more open-ended commitment to countries without imposing debt restructuring has led to a dramatic fall in Irish bond yields. 10-year yields have fallen from over 14 percent to under 9.5 percent. Even more dramatically, 2-year yields have fallen from 23 percent to under 9 percent. Clearly, the measures taken at the summit were not enough to stem the doubts about the creditworthiness of Italy and Spain, and their yields continued to drift upwards in the days following. Subsequent intervention by the ECB – really the only entity with the firepower to make a credible commitment to a sufficient backstop – has been quite successful in shifting from a bad equilibrium where expectations of default change the fundamentals and risk becoming self-fulfilling.
None of this is to say we are anywhere near out of the woods. More bad luck has come with increasing signs of a significant global slowdown, which jeopardises debt sustainability for many countries. There are also lingering doubts that the ECB and other major central banks have the stomach and political support to do what is necessary to act as backstop for financial systems, though I believe these doubts will prove unfounded.
Having this strengthened backstop is effectively to move decisively towards what Peter Boone and Simon Johnson label a “moral hazard regime.” It is no surprise that the governments of countries taking on more risk to backstop the system want strengthened fiscal discipline to replace market discipline as far as possible, not least because of the constraints of domestic politics. This is what the Paris summit was all about, although the efforts may have been a bit clumsy and there is a long way to go to workable institutions. Commentators here might ask themselves how they would react if Ireland was in the stronger group and taking on a large contingent liability relating to weaker countries. European crisis-resolution mechanisms are moving in the right direction as the nature of the trade-offs is better understood. We could have a more constructive and informative debate if we spent less time harping on about the stupidity of others.
At least so far, it appears ECB intervention has been successful in significantly lowering Italian and Spanish bond yields.
Paul Krugman has a nice little post using the idea of multiple equilibria to explain how such interventions might work, even with what could actually be relatively modest bond buying.
If your appetite for multiple equilibria models is whetted, here is a fascinating paper by Paul in which he explains the self-fulfilling crisis logic in much greater detail, though it is in the context of a currency rather than a debt crisis. The comments at the end by Kehoe and Obstfeld are also well worth reading. Interestingly, Paul is quite circumspect in the paper about the quantitative importance of multiple equilibria, putting more emphasis on steady deterioration in the fundamentals.