Banks Aren't Lending Because of the "F" Word: Foreclosure

Jan 24, 2011Mike Konczal

Since banks have cash in their pockets, why aren't the lending gears grinding?

There was lot of interesting back-and-forth on balance sheet recessions at the end of last week. Here are Ryan Avent and Mark Thoma each explaining the argument. David Beckworth pushes back on the concept here (as well as here):

[T]he explanation incorrectly assumes the entire U.S. economy is on a deleveraging cycle....[The balance sheet recession view] fails to recognize that for every debtor there must be a creditor. Thus, for every debtor who is cutting back on spending in order to pay off his debts, there is a creditor receiving money payments. In principle, these creditors should be increasing their money spending to offset the decline in money spending by the debtors -- but if that were happening, there would have been no decline in overall total current-dollar spending. Instead, creditors are sitting on their money because they see an uncertain economic future...

If these creditor households, firms, and banks all simultaneously started spending their excess money balances, this would increase total current-dollar spending and in turn spur a real economic recovery. Moreover, knowing that the real economy would improve would feed back and reinforce current spending decisions by the creditors -- creditor households would buy new cars and remodel their kitchens, creditor firms would build new plants, and creditor banks would increase lending. A virtuous cycle would take hold and push the economy back toward full employment. But this virtuous cycle is not taking off because creditors are still hanging on to their money balances. What is needed to kickstart this cycle is an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously.

Enter the Federal Reserve. It alone has the ability to provide these incentives through its control of monetary policy. The fact that total current-dollar spending has remained depressed for so long means that the Federal Reserve has failed to do its job and effectively has kept monetary policy too tight.

Andy Harless writes a comment I agree with:

"why aren't the creditors who are receiving the increased payments spending the money?"

There's no reason to expect them to spend it, because it's not income; it's just a return of capital. The question would be, "Why aren't they re-lending it?" The reason they aren't re-lending it is that, with debtors trying to pay down their loans, the demand for loans is too low to produce high enough interest rates to justify the risk. You can call it an excess money demand problem, but the excess money demand is a result of the balance sheet problem, because money happens to be an asset that becomes attractive when loan demand is weak.

There are two questions to be answered. The first is whether or not we are on a deleveraging cycle and what the consequences of this would be. The second is whether or not fiscal and/or monetary policy can impact deleveraging.

The economy is deleveraging; that's not made up. The Federal Reserve's latest quarterly Fed Flow of Funds came out last week, and consumers continue to delever:

You can also see this at the FRBNY Consumer Credit Panel.

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What are the consequences of this? I want to recommend this excellent presentation (pdf) by Karen Dynan of Brookings, who walks through likely consumer spending scenarios related to consumer deleveraging. She finds that there is more to come. It certainly looks like consumers are develeraging too fast for it to come just from households paying down debt. Indeed, Dynan finds that a large majority of the deleveraging is coming from writing off bad debt.

When there's a charge-off event, two things happen that are relevant to whether or not the money is relent. The first is that the borrower signals he or she is a credit risk, which will reduce access to credit. The second is that the lender's probability of financial distress goes up, so they want to be more restrictive in how they lend; they have suddenly gotten themselves in the real estate business through replacing a debt asset with an abandoned home in a flooded market. This is the opposite problem of someone saving too much and becoming a better credit risk while a bank has too much to lend.

I think the spillover effects from foreclosures, abandoned properties, limbo REO houses, etc. are real and have consequences for consumer spending, borrowing and investments in neighborhoods. That at least some, if not many, of these foreclosures are the result of a broken, too-thin servicer model is one reason I spend so much time arguing for moving foreclosure negotiations from servicers to bankruptcy judges. We can fix a lot of this with a Chapter M for Mortgage expedited bankruptcy process (and some inflation).

Sometimes people float the argument that mass foreclosure waves should boost consumer spending power, since those homeowners are getting free rent. I think that overestimates how many people stay in their house once foreclosure starts. There's evidence that many people who are delinquent on a first mortgage are still paying junior lien claims. And if you are losing your home, you often have had an unemployment spell; it's not clear that you've boosted your income.

There's other criticisms of this approach. JW Mason reminds us that claims that fiscal consolidation will reduce aggregate income are empirical, ones that are likely true but that we shouldn't take for granted.


Mike Konczal is a Fellow at the Roosevelt Institute. **Don't miss Mike speaking with CNN about the nature of our unemployment crisis here.

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