Why debt reduction for households is not a good idea

Editor’s Note:  As the financial crisis has widened, some analysts have asked the U.S. government to consider debt relief for American families who are struggling with mortgages they can no longer afford. Mauricio Cardenas explains how a previous crisis in Colombia offers lessons for the U.S. and argues that U.S. government debt relief is a bad idea.

As many other Latin American countries, Colombia faced a severe financial crisis in the late 1990s originating mostly in the mortgage industry. As now it is now the case in the U.S., the root cause of the problem as a rapid increase in Loan-to-value ratios that made delinquencies climb to unprecedented levels. This was the result of an implosion of real estate prices after the housing bubble of the mid 1990s. To make things worse, the value of the loans rose as a result of the system of mortgage indexation in place at that time (as bizarre as it may sound mortgage principals were indexed to the nominal deposit interest rate). The natural consequence was an increase in delinquencies that make the current U.S. crisis pale in comparison (see figure).

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How did Colombia deal with this situation? In addition to discarding the existing indexation system, the government responded by adopting four measures:

1. Large banks that were too weak to survive were intervened by the government (smaller banks were allowed to fail). The government then appointed new administrators and injected capital. The cost of these rescue operations were approximately 4 percent of GDP. About two thirds of this amount was later recovered by selling two banks in 2005-06. The government still owns a large bank. Not a bad deal.

2. A facility was created to provide capital to private banks. To access this facility banks were required to put their distressed assets outside their balance sheets. The government took preferred shares, while shareholders had to provide more capital and lost control over key decisions including dividends. The preferred stock received interest. All these loans were paid back and the government made good money because interest rates were not low or subsidized.

3. A facility was created to collect the toxic assets of the government owned banks. This entity began gradually sold those assets at market prices. A large chunk of the remaining assets of this entity were auctioned in 2007 at a profit to the government.

4. Write downs and other forms of debt relief were given to mortgage debtors The Colombian Treasury issued debt that was given to the banks in exchange for the write offs (with a cost to the banks because these bonds paid a lower rate than the original mortgages). On average about 15 percent of the original debt was taken out of the households’ balance sheet. The cost to taxpayers was equivalent to 1.6 percent of GDP. This money was never recovered and helped very little to solve the problem.

It is now argued here in the U.S., as it was then said in Colombia, that households have too much debt while their assets are losing value. Congress is echoing the idea that households are buried under a pile of debt that is essential impossible to pay. In addition, if everyone is getting relief, why not families?

If you look closely at the figure above, non-performing loans did actually decrease momentarily right before the relief announcements (loans had to be performing to be eligible) but increased dramatically afterwards. The reason is simply that households believed that there was more aid coming if things got really bad. In other words, the relief ruined the incentive to pay. And nothing can be more damaging for the health of an economy that that. This is a bad idea that the U.S. has to avoid, not because it is costly and ineffective, but because it aggravates matters.

3 Responses to "Why debt reduction for households is not a good idea"

  1. Takeo Hoshi
    Takeo Hoshi   September 29, 2008 at 10:34 am

    Very interesting, though the figure is a little bit hard to see. When was the debt relief announced? Around July 2000?

  2. Renee   September 29, 2008 at 2:31 pm

    Was 15% debt reduction significant enough to make a difference? It’s hard to imagine if you reduce a household debt enough that people would still choose to walk out. So all I can extrapolate from this piece of information is that the household debt relief either wasn’t implemented properly, or it just wasn’t enough. The devils are in the details afterall.

  3. Anonymous   September 29, 2008 at 10:25 pm

    The premise of the article, that debt relief to consumers “helped very little to solve the problem” is dealt with in one sub-clause of one sentence. I have quoted the entirety of the argument advanced.In other words, the author stated his opinion. And not much more than that. Evidence in support of the proposition woulda been nice. (though granted, as is it makes for a catchy title….)