IMF Study Presents a Clear Blueprint (in Theory)
The global recession continues to batter our financial shores, and world governments are working non-stop to implement programs designed to restore the financial viability of borrowers and promote debt relief. There are numerous theories regarding just how government should go about assisting populations as they progress toward debt relief. Whether their action should be a) measured and look toward long-term stability or b) immediate in order to quell the pain the general population is facing and jump-start the economy through multi-billion dollar stimulus is being debated across the globe.
A June 2009 study by Luc Laeven and Thomas Laryea of the International Monetary Fund entitled “Principles of Household Debt Restructuring” (see http://www.cnbv.gob.mx/recursos/fmitsr24.pdf) states that any government-sponsored program to promote debt relief should help individual borrowers while at the same time minimizing fiscal cost, reducing the possibility that banks will fail and establishing the a clear plan for real recovery. Unfortunately, it is unclear for nations like the United States whether such a clear plan is in place.
What Should the Structure of Government Aid Be?
Laeven and Laryea suggest the following framework:
- Clear Objective: Troubled loans (bad debt) must be converted. Debt service requirements might be reduced for some borrowers who are suffering due to interest or currency exchange rate explosion.
- Scope of Debt Relief: Helping those who cannot satisfy their debt but would likely be able if debt restructuring were to occur. The criteria for choosing such borrowers would be difficult, and would have to be feasible within the envelope of public funds received to operate the debt relief program.
- It Must be Proportional: Bring the greatest aid to those who are in the greatest need.
- Voluntary Participation: Banks should not be forced to restructure borrower debt, as this will give rise to legal challenges that will hinder the debt relief process.
- It Must be Simple: Household debt involves a large sample of loans, so simple rules are needed if systemic abuse is to be avoided. The government and banks must share information in order to conduct analysis of debt load.
- There Must be Transparency and Accountability: President Obama promised transparency during his tenure. This kind of openness is essential in order to perform the analysis necessary for debt relief using public funds. All organizations involved should know where the money is going, and if a mistake is made or there is an intentional infraction, those responsible should be required to stand accountable.
Unsustainable Debt Requires Swift but Sure Action
The world financial crisis has hit many countries hard. Household debts on the individual level (as well as the ability to service such problems) create a downward spiral from which it is difficult to escape toward debt relief. Financial institutions reel in the face of consumer financial paralysis, as their own balance sheets will with non-performing loans. As a result, banks tighten the rains on available credit, which in turn affects housing prices and the value of other assets. This lessening of collateral value comes back to hit households where it hurts. Consumption goes way down, which hurts retail and leads to unemployment. Greater unemployment contributes mightily to slackening income figures.
Turn Frowns Upside Down? How?
How will society effectively deal with the massive volume of distressed loans? Government involvement will necessarily bring costs; what we have to decide is whether the benefit of their involvement in debt relief outweighs said costs. Any government spending to affect debt relief should be tempered by the need to remain fiscally responsible, suggest the study authors.
The rise in personal bankruptcies and foreclosures presents an important hurdle for government involvement in debt relief. Working each case out individually through the court system is hardly efficient. A gridlocked system based on allowing the market to correct itself – while legal fees mount – suggests in the minds of the authors that a more organized debt relief approach from world governments is necessary.
Is Government Debt Relief Feasible or Credible?
This is an interesting question. If intervention can produce real gains in helping to alleviate public debt without abusing the will of taxpayers, perhaps governments should move forward. The study authors remind us that if debts are written down in value, banks will need their own recapitalization programs in place. These programs should be tuned toward establishing solvency for the financial institutions, rather than gross profits.
The Case-By-Case Approach
If government agencies can assess the current size of the financial problem they face by determining
- An accurate, current picture
- The problem’s evolution to this point
- How the financial burden has been concentrated across a sample of individual banks
- How debt relief via restructuring will help these lending institutions,
then Laeven and Laryea figure that the path for government involvement would be open.
The approach to the problem should advisably first focus on case-by-case debt relief (when numbers make such an approach feasible). Dealing with household insolvency through a framework that addresses collection enforcement, the value of collateral after debt is secured, loan modification that respects the capacity for debtors to pay and (in some cases) debt relief via discharge after a liquidation period. While this framework would address legal issues, the authors suggest that governments could also offer incentives and make loan restructuring easier by promoting such things as nonbinding private sector guidelines for the restructuring process.
Across-the-Board Government Subsidies
When a case-by-case approach isn’t feasible, the authors suggest government-sponsored debt restructuring for debt relief. This would involve direct financial support to debtors. Some or all loans could be covered, where the government would give funds to banks that agree to restructure loans. The creation of asset management companies that buy and resolve bad debt would be another approach. In addition, household subsidies along the lines of debt forgiveness or interest rate/tax rebates are options under this plan.
Ideally, only those who are honestly unable to repay their debt could take advantage of such across-the-board government debt relief programs. Determining a person’s ability to pay is tricky business. “Debt restructuring,” write the authors, “should not be regarded as an instrument that can displace sound macroeconomic policies.” Caution and close study would be needed.
A Restructuring Plan
This would include a variety of incentives and reforms, claim the authors. It begins with incentives for borrowers, where they are encouraged to restructure their loans with a series of subsidies. There would be subsidized refinancing, write-offs and insurance against being harmed by exchange or interest rate hikes in the future. In the area of bad mortgages, the authors state that shared appreciation mortgages might be one way to go. Repayment would then necessarily be related to the value of a home when it is sold. These mortgages could be written so that governments could share in the upside as value appreciates.
Lenders could also receive their share of incentives. Tax credits for those who agree to restructure loans or even access to low interest credit lines as a reward are not out of the realm of possibility in Laeven and Laryea’s plan. To help prevent an endless chain of recapitalization aid, the government could also create “an effective personal bankruptcy framework for addressing collective enforcement of creditor claims and rehabilitation of debtors.” Helping borrowers in that case could also help lenders.
Foreign Currency Loans
Considering that the authors compiled their study for the International Monetary Fund, it comes as no surprise that the issue of foreign currency loans is addressed. They suggest such loans could be converted to local currency, and when the exchange rate problem becomes too prohibitive, liquid assets denominated in the original currency could help make up the difference.
And as a Last Resort…
When the above measures aren’t enough, the authors believe that a new standard for modifying bad loans is needed, as well as temporary bans on foreclosure and repayment. Governments who delve into these areas do so at their peril, however, as lending contracts are superseded. The market could begin to view contract enforcement capability in a negative light, which would diminish investor confidence. In that instance, debt relief is not procured and incentives to default are unintentionally created because the danger of penalty is not so near.
Debt Relief Through Asset Management Companies
Of the ideas Laeven and Laryea present, debt relief through the use of asset management companies has the most promise in my eyes. Such companies would be better equipped to resolve bad debt than the already overtaxed lenders who require recapitalization. Then, on a case-by-case basis with banks, the government can be more selective as to where taxpayer dollars go to help. The relative strength of a financial would be taken into account.
Various Countries are Applying Variants of These Ideas
However, there is no one solution that works for all nations. Debt relief is necessarily a long, slow process, one that individuals may not be able to stomach as they stare down their monthly slate of bills to pay. But for lasting change, it appears that slow reform may be the only route for true debt relief.