First of all, some history of what has already been done. Consider the following example : suppose you borrow 100$ from a bank for 2 years to buy a house. The APR is 10%. If it is a mortgage then if you don’t pay, the bank gets your house (this is what is called foreclosure). Suppose you make a payment of 50$ in the end of the first year and the rest of the debt in the end of the second year. Then evolution of payments looks like that:
|Time period||House price||Debt before the payment||Payment||Debt outstanding||Equity|
If house price evolves in the way it is described in the table, you end up with equity equal to $150.” Shareholder’s equity” is the difference between your assets (the house) and liabilities (the mortgage).
Now suppose things don’t go that well and the evolution of house’ s price is different
|Time period||House price||Debt before the payment||Payment||Debt outstanding||Equity|
Now suppose that things don’t go that well and the house’s price decreased, instead of increased, say to 50$. Well, in this case your equity in the end of the year 1 is negative. This is called being underwater. Would you be willing to pay the bank even 60$ if you had these 60$ in the end of year 1? Maybe, but you would probably think twice. As soon as you equity becomes negative, having mortgage is like paying expensive rent for the house.
What can the bank or government do in this situation and what was actually done?
- Decrease the interest on the loan? Would it work? No, just because your equity is already negative in the end of the first year. If the bank says that the APR is now 5% it wont make any difference because it still not worth it paying the mortgage in the end of year 1. But this is what 70% of voluntary modifications were about – missing payments and fees were added at the end of year 1 making the equity even more negative and less attractive for homeowners. So it should be no surprise that the number of foreclosure has actually increased not decreased and people ended up even deeper underwater.
- Would it make a difference if the bank decreases the amount of the principal (the 60$ at the end of year 1)? Yes, because your equity becomes positive and it is profitable for homeowners to keep paying. There are programs out there that advocate for this.
Why did not this happen? Because banks would have lost money! Moreover, some people might stop paying just because they think their principal would be reduced. Another potential problem: second liens. Second lien is a loan that was borrowed against shareholder’s equity. So the problem is that even if the principal is reduced the homeowners would still be underwater, because the injected money would just be a gift to the servicers of the second liens.
- Government can buy mortgages from the banks for a discounted price (most of the morgages are valued from 30 to 50 cents per dollar and most second liens several cents per dollar) and then reduce principals to make loans affordable to consumers and then when the homeowners are back on track sell the motgages to the banks potentially for a slight profit. Problem: banks might not be willing to sell mortgages for a discounted price simply because they know the government would want to buy them.
- Government can legally take over mortgages using so called “eminent domain”. This method is used when a new freeway needs to be built in some area or the area is contaminated and needs to be demolished. Basically the government tells the banks that they the houses belong to the government and the banks get market price for it. Of course, not all mortgages should be acquired – only owner-occupied. No Congress approval is needed for this action. The money from allocated for the previous (unsuccessful) modification program – HARP – can be used. Too harsh? Not democratic? Well, it was a democrat congressman who suggested it. A similar program was run by FDR in the 1930s. Moreover, the banks generally already have been treated too nice by the government since the beginning of the recession. This action will also encourage other banks to modify the mortgages they own if they want to keep them.
General problem with loan modifications: mortgage back securities, sometimes called “toxic assets” that many investors have. What are they? The picture below should help:
In fact, many banks do not own the mortgages themselves. They resold them to companies like Fannie Mae and Freddie Mac, who pooled the loans in several pools depending on how likely people that own the money are likely to repay the mortgages. After that these pools were split in securities (like “shares” of the pools) and sold to different investors. This process is called “securitization”. Investors were supposed to be paid when people pay their mortgages. Further, there exist financial derivatives (stocks that depend) on these MBS such as credit default swaps (CDS) that pay if a person defaults on his mortgage. In other words, default on the mortgages is profitable for the owners of CDS on them (you don’t have to even own the mortgage to own a CDS on it). So any action by the government would benefit some people and hurt others, so as Adam Levitin put it
the government needs to settle on its policy goal. Why are we trying to prevent foreclosures? Is it a macroeconomic goal of stabilizing the housing market? Is it a macroeconomic goal of deleveraging consumer balance sheets? Is it a moral goal of helping unfortunates? Is it an electoral goal of making people feel that the government is doing something/is on their side?
And then do something, not just say everything is alright. Because 9% unemployment for 3 years is not alright, even if fundamentals are fine.
Everyone is worried about whether a double dip recession is on the way. Google search for “double dip recession” gives millions of results with fresh articles and posts in most major media websites : MSNBC, NY Times, USA today, WSJ and others. Many media are being very pessimistic about it, claiming that the economy has already entered another recession, other caution that it is possible. For these reasons, I decided to review several recession indicators used by economists. These are not the same than those usually mentioned in the media. t. Quick answer to the question whether we are in another recession is : nobody knows and simply cannot say for sure. Why? Read on.
First of all what is a recession? According to NBER, the organization who actually determines whether we are in the recession or not:
A recession is a period between a peak and a trough, and an expansion is a period between a trough and a peak. During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year. Similarly, during an expansion, economic activity rises substantially, spreads across the economy, and usually lasts for several years.
Keywords in this definition are “significant” and “decline”. In other words, during recession economic activity should be declining, not just stay on the same level. Also, this decline should be significant according to NBER committee. So why cannot we say whether we are heading into a recession or not now?
- New monthly data calculated by NBER and used to determine whether the economy is in the recession is very noisy. Numbers often get revised later. For example, some economists who use econometric methods to forecast future values of GDP found that using the last observation when it becomes available makes the prediction for the future periods worse. For this reason NBER usually waits 6 to 21 months. For example, the committee determined that there was the peak in 2007 11 months after it had occurred.
- Only if many indicators reach a peak, NBER declares that this was a peak. Same happens with troughs. Looking on one indicator, such as GDP or the unemployment rate, is not enough.
OK, that is good, but what if somebody does not want to wait a year or more for NBER finally announcing that there actually was a recession today? NBER uses the following list of indicators (xls source for this information with some data):
- GDP, NIPA table 1.1.6
- GDI, NIPA Table 1.7.6 (“I” stands for income)
Source for this data is here
- Macro Advisers historical monthly real GDP (xls source)
- New Stock-Watson index of monthly GDP (source)
- New Stock-Watson index of monthly GDI (source)
- Real manufacturing and trade sales (SIC befor ’97, NAIC after ’97. NIPA Detailed Tables 2AU and 2BU)
- Index of industrial production (source)
- Real personal income less transfers (NIPA Table 2.6, see source for quarterly data)
- Aggregate weekly hours index in total private industries (source)
- Payroll survey employment (source)
- Household survey employment (source)
Interpretation of all these indicators is straight-forward: if it goes down, the economy is not doing well and if it goes up things are great. All of the source websites present you with the graphs with adjustable time periods. Comparing todays values with the values during past recessions one can see what kind of contraction/expansion in each variable NBER considers significant and makes corresponding conclusion
So what do we see in this data? Seems like nothing bad is going on for now and there is no reasons to panic. Yay! However, if one looks at the growth rates of these variables, you can measure how well the economy recovers. The general answer is that the recovery has slowed down. While there is still no reason to panic, because it might be just noise or it will accelerate soon, it is a warning sign .
But what about other indicators often used by media, such as unemployment rate? Aren’t they indicators of economic activity? Yes and no. They have their own peculiarities and have to be used with caution. For example, quoting NBER, unemployment rate
…often rises before the peak of economic activity, when activity is still rising but below its normal trend rate of increase. Thus, the unemployment rate is often a leading indicator of the business-cycle peak. … On the other hand, the unemployment rate often continues to rise after activity has reached its trough. In this respect, the unemployment rate is a lagging indicator.
And finally, for the dessert, some very interesting high-frequency indicators (because they are not so well-known one has to create graphs him-/herself ) that are available to anyone. The description is available in this post by Rebecca Wilder and the graphs with the recent data is available in this post which I am using here as well. These indicators are
- Weekly initial unemployment claims (These series are not used by NBER due to a lot of noise in it. Rebecca Wilder suggests using 4-week moving average of seasonally adjusted initial claims or its growth rate). For now these series look like that:
Rebecca’s comments about this graph:
Claims are elevated but ticked up last week. If claims do not fall back in coming weeks, the unemployment rate will rise again. This could indicate the outset of a contracting economy.
- The US Energy Information Administration’s weekly estimates of distillate fuel oil supplied to the end user in thousands of barrels per day (real) (This data is not seasonally adjusted. It works as an indicator for domestic demand for goods that are transported across the country). For now it looks like this data shows an increase.
- And the last Rebecca’s indicator is daily Treasury tax receipts that are slowing but growth remains positive
There are other series that are used in media but do not serve as indicators of recession for the US economy. These series include government debt (high levels of government debt do not mean we are in a recession, as long as people believe that it will be repaid. Demand for US bonds is not decreasing!) , inflation (Currently the Fed does not want prices to decrease, not increase! Rising prices for cotton probably mean that the demand for cotton went up. Moreover, inflation would erode government debt which is also a good thing for the US) .
To sum up, it does not seem like we are heading into another recession for now, but there are several signs that the recovery has slowed down.
In any case, in the current situation government has to do something to get the economy from the terrible situation in which we are now. Of course, if aliens do not suddenly attack the United States.