Center for Business & Public Policy
Collaborative blog exploring the relationship between market forces and public policy.

I saw an interesting piece in the New York Times entitled “Debts Rise, and Go Unpaid, as Bust Erodes Home Equity.”  Home equity loans are secured against homeowners’ equity in their homes.   During the housing boom, it was not uncommon for a homeowner to buy a home for, say, $100,000, watch its “value” increase to $200,000, and then take out a loan secured against this increase in the value of the home.  Just by riding housing values up, this homeowner could gain access to a line of credit of up to $100,000.

If housing values continue to rise and people keep working, everybody is happy.  Homeowners can make relatively small payments on the home equity loan and enjoy increased consumption in the short run.  Eventually, when they sell their house at a higher price, they can pay off the loan and everyone wins. 

However, in the face of a national recession and housing bust like we’ve experienced lately, things look quite different.    People have lost their jobs, and so can no longer afford to make their loan payments.   In ordinary times, the lender would seize the collateral for the loan – in this case the house.  However, at the same time we’ve been going through a recession, we’ve also been experiencing a housing bust.  So, the house that had been valued at $200,000 at the time the loan was written may not only be worth $80,000.  The collateral is no longer there.

The result of this dynamic is an increase in defaults on home equity loans.  Faced with financial difficulty, buyers are choosing not to pay their home equity loans and challenging the banks to try and collect.  However, in the case of home equity loans, this can be particularly difficult for banks, since, following bankruptcy, home equity loans are paid off only after primary mortgages.  So, if an equity lender tries to collect, the borrower can simply threaten bankruptcy, in which case the equity lender will most likely get nothing.  Thus, rather than being at the mercy of the banks, households that took out large amounts of debt are actually in a position of power.  To quote a couple of paragraphs from the article:

The result is one of the paradoxes of the recession: the more money you borrowed, the less likely you will have to pay up.

“When houses were doubling in value, mom and pop making $80,000 a year were taking out $300,000 home equity loans for new cars and boats,” said Christopher A. Combs, a real estate lawyer here, where the problem is especially pronounced. “Their chances are pretty good of walking away and not having the bank collect.”

Even when a lender forces a borrower to settle through legal action, it can rarely extract more than 10 cents on the dollar. “People got 90 cents for free,” Mr. Combs said. “It rewards immorality, to some extent.”

This phenomenon points toward an interesting change in American culture that reminds me of a story from my own life.  When I was in graduate school, I would rent movies from Blockbuster Video. (This was pre-Netflix, but at least they were DVD’s!)  I used to take the due dates very seriously, to the point where I’d pull on my shoes and run out at 11pm just to return a movie before the midnight deadline.  Then, one day, I didn’t, and I realized that nothing bad happened to me if I did.  Sure, there was a fine, but it was one I could deal with.  From that day on, I don’t think I ever returned another video on time.

What we’ve been experiencing lately with regard to bankruptcy and loan delinquency is much the same.  There hasn’t been a change in bankruptcy policy.  And, while there has been a change in economic circumstances (some responsible people can’t afford to repay reasonable loans that were taken out in better times), there has also been a cultural change whereby declaring bankruptcy is no longer seen as a last resort.  It has become acceptable to declare bankruptcy strategically, even before all available options for repaying as much of a loan as possible have been exhausted.  And, lenders are now aware of this.

It is difficult to know the impact of this change on lending markets, but it is likely to be profound.  Home equity loans, which used to be straightforward, are likely to be more difficult to acquire, as lenders begin to protect themselves against the possibility of a housing downturn in a world where people feel it is acceptable to walk away from their obligations.  These protections will likely involve fewer loans, smaller loans, higher interest rates and stronger collateral requirements.

When the financial crisis hit last year, a lot of news sources started speculating that people would be forced to work longer to make up for the losses in their 401(k) plans.  Yet there seemed to be some puzzlement when data started indicating that more people were retiring earlier.  What happened here?

Some new research sheds a bit of light on this.  The answer to the puzzle is essentially that there are different groups out there who were affected differently.  Higher income individuals with large 401(k) balances were indeed likely to postpone retirement as a result of the negative wealth shock.

However, the financial crisis was also accompanied by a deep and prolonged recession that significantly increased unemployment, or more broadly, joblessness.  A study by Courtney Coile and Phil Levine of Wellesley College shows that a rise in unemployment during a recession leads to earlier retirement.  In essence, older individuals choose to retire rather than try to find another job. 

In aggregate, it appears that the unemployment-induced increase in retirement outweighs the 401(k)-loss-induced delay in retirement.  The net result is the average person retiring earlier, not working longer.

Of course, the most important point of all is that both effects are likely to reduce retirement security.  Whether forced out of the labor force early due to job loss or forced to stay in the labor force longer due to a negative wealth shock, individuals are made worse off.  And that, ultimately, is the real story.

Many college seniors are looking for a job.  They know that the first job may be important for their whole career path, because the quality of the experience on the first job may affect future prospects.  They also know that we now face a recession.  The economy is bad, and jobs are scarce.  What you may not realize, however, is that those two problems compound each other; the combination is even less than the sum of the parts.

Those who graduated last year and those who graduate this year during the recession might experience trouble finding their first job or may take an initial job that is less than they had hoped, because of the recession.  Moreover, they may experience long lasting effects of the recession, even after the recession is over.  The evidence is presented by Lisa B. Kahn, a professor at Yale University, in a research paper called:   “The Long-Term Labor Market Consequences of Graduating from College in a Bad Economy”.

She studies job market outcomes and educational attainment for a sample of individuals over time, using data from the National Longitudinal Survey of Youth (NLSY).  In order to avoid various complicating factors, she limits the study to a sample of white males who graduated from college between 1979 and 1989.  The main event at the time of graduation for some of them is the recession in the early 1980’s, but then she follows all of those individuals for the next 20 years.

She uses variation both in the national unemployment rate over time and in the local unemployment rates across states, and she finds that higher unemployment rate at the time of graduation has persistent, negative effects on wages of those individuals.  The initial wage loss is 6 to 7% for an extra 1 percentage point in the unemployment rate. This effect falls by approximately a quarter of a percentage point for each year after graduation, but it is still a 2.5% wage loss even 15 years after college graduation.

In other words, seniors who graduate in a bad economy are unable later to shift after the economy improves into the jobs they would have had without the recession.  For all of these reasons, a higher proportion of graduates during a recession choose not to look for a job right away, but to stay in school and go for a graduate degree.

I’m not sure what the individual senior can do about this problem, but it certainly has implications for government policy.  In particular, it means we ought to try even harder to avoid recessions similar to the one in the early 1980’s, or the one now in progress.  The costs are greater than the temporary unemployment.

We write this blog for the University of Illinois “Center for Business and Public Policy” (CBPP), which is NOT the same as the Center on Budget and Policy Priorities.  That other center provides some useful information, however, such as the new report on state budgets.  It says “48 states have addressed or still face shortfalls in their budgets for fiscal year 2010, totaling $178 billion or 26 percent of state budgets.”

The most famous example of a state fiscal disaster is California, which accumulated a total gap during FY 2009 of $37 billion (equal to 36.7 percent of the states general fund).  The state later issued IOUs instead of actually paying for some services.

While the long-run fiscal problems of the Federal government are severe and well documented, the short-run budgetary problems in Washington, DC are simple compared to those at state capitals across the country for two reasons.

First, almost all states have balanced-budget statues.  (In fact, only Vermont allows deficit spending.)  The inability to run budget deficits during a recession limits the options of governors and state legislatures when dealing with shortfalls.  Indeed, standard doctrine suggests that governments should run deficits during recessions to stimulate economic activity.  Without the deficit spending option, states must cut expenditures or raise taxes, exactly the opposite of what they should be doing to counteract the downturn.

Second, this particular recession has put a great strain on state revenues due to the collapse in housing prices and the steep decline in consumer spending.  Unfortunately, most states rely on property taxes and sales taxes for revenue, instead of income taxes.  Yet housing prices are unlikely to rebound soon, as a glut of foreclosures remains in many states.  Also, it appears that consumers have  shifted to a higher savings rate, which lowers sales tax revenue.  Potentially, tax rates could be increased to cover the budget gaps, but that option is politically difficult during recession.

In response to these two problems, the Federal government has increased transfers to the states as part of the American Investment and Recovery Act.  Since the Federal government CAN run a deficit, these transfers help get around the balanced-budget statutes and allow for less draconian state expenditure cuts.  However, the lag in revenue recovery at the state level still means years of tight budgets ahead.