The biggest single problem facing the economy is the tremendous overhang of debt, particularly real estate debt.
It is clear to most observers that the economy will not return to a sound footing until the real estate market recovers. And this requires a resolution to the situation in which debt on many properties exceeds their value.
Normally balance sheets can be restored by selling assets to pay down debts. Because of the tremendous fall in values of residential and commercial real estate, massive foreclosures are necessary, unless another way out of the debt situation can be found.
I believe a simple change to our tax code can cut through the malaise and offer widespread economic relief at little cost.
Options
Repayment normally is the best option for debt. But this isn’t possible for some debt. In all previous postwar recessions, the vast majority of debt could be repaid as the collateral backing the loans still was worth more than the loan.
The economy was able to rebound in a year or two so income increased, easing the repayment burden. The foreclosure process was needed for only a tiny portion of outstanding debt.
It is estimated that more than 25% of homes now are worth less than their loans.
Office, industrial and retail buildings on average have fallen 40% or more in value. For an industry that typically uses 60% to 75% leverage, this amounts to an equity wipeout for a sizable percentage of the industry.
The prolonged downturn has limited a rebound in asset values. And any chance of significant recovery in the near future seems remote. Incomes remain depressed, making repayment from earnings at best a minor contribution to debt reduction.
Debt also can be extinguished through foreclosure. But this is a tremendously expensive procedure in human terms as well as in the destruction of asset value.
For a society, foreclosure is manageable when it only applies to a tiny segment of the population. Avoiding foreclosure for a large segment of the population, if at all possible, surely is a worthy goal.
Bankruptcy has many of the same economic and human costs and also results in significant losses for the lender. Widespread bankruptcies can result in losses to the banking system, which lowers bank capital and reduces lending, making it even harder to rebound economically.
The debt burden also can be reduced through inflation. But inflation can become extremely dangerous if it gets out of hand. It is ironic that we have the lowest inflation in decades at precisely the time that a little more inflation would be helpful.
But it takes several years for inflation to have its effect on the level of debt, and it is not clear that the Fed could create inflation in the current economic environment, even if it wanted to.
This leaves forgiveness of debt by the lenders as the least painful option, especially for the borrower. Some form of widespread debt relief would be the best option for the economy and society in general.
But lenders naturally are extremely reluctant to forgive debt, unless somehow it becomes in their best interest to do so.
Consider a program where banks and other lenders are given incentives to forgive mortgage balances in excess of current property values. The truth is that because of the tremendous cost of going through foreclosure, lenders would not come out that much worse if they forgive these amounts.
This said, it would be difficult to get a significant level of participation on a voluntary basis without incentive.
Incentive
A simple change in the tax code, as well as related regulatory changes, could make dramatic changes in lender motivation regarding loan forgiveness. What if lenders participating in this program were allowed to write off debt forgiveness given in 2011 over 12 years? It would certainly increase profitability in the next few years and probably in the long term as well.
Lenders are going to have to face losses on underwater real estate eventually. In fact they have been building reserves against such losses in the past several years and already have accounted for a sizable portion of the losses.
Government tax collection would not be hurt, as deductions from losses would be offset by renewed growth in the economy.
It’s not quite as simple as it sounds. Such a plan would require coordinated rule changes from the IRS, the Securities and Exchange Commission, the Financial Accounting Standards Board, the Federal Reserve and other bank regulators.
Protection from litigation to participants would need to be provided.
The government has tried several complicated loan forgiveness programs without much success. To be effective, this one must be simple and widespread. A program open to all would be best. It would be much more effective in stimulating the economy if it included commercial as well as residential real estate.
It won’t be easy. But such a program could have a dramatic effect on the economy and many people’s lives without the debt burden associated with traditional Keynesian stimulus programs.
Saunders is a real estate investor and owner of London Coin Galleries Inc. in Newport Beach.
