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S. Hrg. 113-55 State of the American Dream: Economic Policy and the Future of the Middle Class
Hearing before the Subcommittee on Economic Policy of the Committee on Banking, Housing, and Urban Affairs
First Session on Examining The State Of The Middle Class And The “American Dream” Today From Personal And Policy Perspectives
June 6th, 2013
For the full transcript please click here.
June 6 2013, 9:35AM. Room SD-538
In particular, I will just give the example of mortgage contracts, the way they have been written in the past and how they impacted the middle class and the economy. When the decline in house prices happened starting in 2007-08, people had most of their wealth in their homes. They lost all of that wealth, but that was not all. Many of them continued to use their retirement income to pay off the debt on a house that did not belong to them anymore because they were underwater.
That is the first impact of the financial crisis, and it is a direct consequence of the way we wrote down those mortgage contracts. The net impact of that on the American middle class has been devastating, and the enormous impact it has had in increasing wealth inequality in the U.S. is really remarkable.
The other important thing is that it is not just a question of middle class. Because we live in an interdependent ecosystem, what happens to middle class has a wider impact on the rest of the economy through two key channels in the mortgage context. One is the foreclosures that are imposed as a result of homeowners being underwater devastate home ownership across the country due to the fall in house prices that results from foreclosures. The other negative impact is the aggregate demand effect. When people lose wealth on their homes as they become underwater, they cut back on their spending drastically, and it is the middle America that has the highest propensity to consume, to spend.
The bottom line is that it is a result of the contracts that we decided to write down, the mortgage contract, that leads to this destruction of wealth of middle class as well as the decline in aggregate demand and the overall economy.
So what can we do to rectify this situation, to prevent it from happening again? We need to have smarter contracts and smarter policy. I have laid out the details (page 55 of this document) of what I refer to as “the shared responsibility mortgages.” These mortgages are very similar to your standard 30-year fixed-rate mortgages, with two important differences: the first one is that these mortgages offer downside protection for the homeowner based on her local house price index that is easily available these days. Under this protection, the standard 30-year fixed-rate mortgage payment, for example, will decline by X percent if the local house price index declines by X percent relative to when the mortgage was originally issued. It is very easy to implement, and think about what would have happened: there would be no such thing as an underwater homeowner, no foreclosures, and we would have prevented the negative externalities that I talked about.
Now, one cost of doing this is that the lender is going to charge more up front for the protection that they are going to offer. So for that, I am going to offer a second suggestion, which is that we add to the mortgage contract a 5-percent net capital gain that will go to the lender whenever the homeowner chooses to sell their house or refinance their mortgage. Given the average appreciation in house prices and the average volatility in house price growth in the U.S., if you do the math, one can show that the 5-percent net capital gain sharing with the lender completely neutralizes the cost of the downside protection that the lender offers. And so we come back to the same cost for mortgages as we have under the current system, but, importantly, this suggestion gives us the opportunity to share risks equally across the population. It protects the middle class and it protects our overall economy and our overall labor market.
If we had this system in 2007—and I have worked through the numbers—one can show that we would have largely avoided the Great Recession itself. In fact, if you think about the details, the proposal is entirely market based. There is no subsidy from the taxpayers involved ever. In fact, the shared responsibility mortgages help reduce budget deficits in the long run because they limit the need for countercyclical fiscal policy in the first place.
These mortgages give the lender a direct interest in worrying about potential bubbles, so that automatically imposes a safety valve in the system so the lenders will lean against the wind, so to speak, if they think they are in a bubble, because they are offering the downside protection so they will raise the interest rate or the cost of a mortgage if they think the housing market is in a bubble. So not only do these mortgages reduce the negative effects of the housing bubble, but they also reduce the likelihood of those bubbles from happening in the first place.