The necessity of deleveraging

By Felix Salmon
February 3, 2011
Bethany McLean has an excellent column on the FCIC report, concentrating on the explosion of debt among both homeowners and banks. The numbers bear repeating:

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Bethany McLean has an excellent column on the FCIC report, concentrating on the explosion of debt among both homeowners and banks. The numbers bear repeating:

From 1978 to 2007, the amount of debt held by the financial sector increased twelvefold, from $3 trillion to $36 trillion…

The end of the housing market’s era of financial sobriety came, by one plausible reckoning, with passage of the Tax Reform Act of 1986. That much-praised legislation ended the tax deductibility of interest on credit cards and other consumer debt but left in place the mortgage interest deduction…

The numbers in the commission’s report chart the surge in housing-related debt: “By refinancing their homes, Americans extracted $2 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996.” Of course, all of this came at a cost: “Overall mortgage indebtedness in the United States climbed from $5.3 trillion in 2001 to $10.5 trillion in 2007. The mortgage debt of American households rose almost as much in the six years from 2001 to 2007—more than 63%, or from $91,500 to $149,500—as it had over the course of the country’s more than 200 year history.” This was during a period when overall wages were stagnant. To cut the figures a different way, as the commission helpfully does: Household debt rose from 80 percent of disposable personal income in 1993 to almost 130 percent by mid-2006. More than three-quarters of this increase was mortgage debt.

On top of that, Citi was operating at 48-to-1 leverage, if you include its SIVs and whatnot; Frannie had 75-to-1 leverage; and Bear Stearns, with $12 billion in equity at end-2007, was borrowing as much as $70 billion overnight.

What does all this devastating debt have in common? It’s tax deductible against income. The more you pay in debt service every year, the lower your taxable income. And so both banks and homeowners have a strong incentive baked into the tax code to load themselves up with as much leverage as possible.

One of the saddest things about the departure of Paul Volcker from any formal role in the Obama administration is that the strongest voice in favor of ending the tax-deductibility of corporate debt service has now been muted even further. It’s pretty clear that households loaded up on home equity lines largely because they were so attractive from a tax perspective: normally people are pretty shy about putting their homes at risk that way. And banks just threw all risk management out the window, to the point at which the top brass didn’t even know what exactly was going onto their ballooning balance sheets.

When the US revamps its tax code, as it must, it should tax the things it wants less of, like debt and carbon emissions, while reducing taxes on things it wants more of, like income and employees. Yes, that means the mortgage-interest tax deduction must be abolished. But it also means that we have an opportunity, here, to revamp the tax code in a way to improve the systemic stability of the economy. Let’s not waste it.


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