The upside of mortgage default

By Felix Salmon
June 2, 2010
Jingle Mail 2.0" on Tech Ticker this morning, and Henry Blodget made the good point that freeing up mortgage payments for small-business operating expenses or consumer goods does provide a short-term boost to the economy -- at the expense, of course, of banks' balance sheets.

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I talked about “Jingle Mail 2.0” on Tech Ticker this morning, and Henry Blodget made the good point that freeing up mortgage payments for small-business operating expenses or consumer goods does provide a short-term boost to the economy — at the expense, of course, of banks’ balance sheets.

I’d be interested to see a economic take on this. In theory, the economy should be better off when you’re spending your money on mortgage repayments, because those repayments go straight into bank equity, which can then get levered 10X in the form of new bank loans. Similarly, if you stop making your mortgage repayments, the write-down at your bank can be enormous, and comes out of that bank’s equity, and therefore provides a significant constraint on that bank’s ability to make new loans.

But in the real world, things don’t seem to be working like that. The banks seem to be making good money while being very parsimonious in terms of new lending: all indications are that they are hoarding equity no matter what their customers do. Meanwhile, the money which would otherwise go to mortgage payments has very high utility and velocity: it keeps the employees of small businesses in their jobs, it gets spent at local businesses, and it can transform people’s lives.

And if the banks do end up in another solvency mess as a result of all this? Well, they seem to be good at raising new equity these days, and if that doesn’t work then maybe they can put together some kind of a debt-for-equity swap. So long as their cashflows are strong, a bit more deleveraging in the financial sector would probably do little harm, and might in fact improve systemic robustness.

I wonder though what would happen to mortgage lending over the long term. Right now it’s almost all being underwritten by the government, in one form or another — Fannie Mae, Freddie Mac, FHA, etc. At some point, banks are going to have to step in and take over that business. But when and how will that happen, if borrowers are significantly more willing to default than they ever have been in the past?

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