January 23, 2018 | Dr. Radhika Lobo
Several instances of debt forgiveness, debt cancellation or loan waivers can be found in world history, the recent one where the UP government waived farmer loans, albeit, selectively, being another case in point. Loan waivers imply partial or total cancellation of obligations owed by individuals, corporations, or nations. It may also include gracious gestures by the lender of slowing or stopping the growth of debt.
Loan or debt forgiveness acts have been promulgated for individuals who have availed of student loans or housing loans. In most countries, if a very large corporate becomes severely indebted, the public sector takes it over to avoid closure and ensures that the employees and other stakeholders do not suffer. Alternately it could take the form of debt equity swaps or the creditor may accept preference shares. The panacea offered by the IMF and the moral hazard created by it for that matter, is often quoted when solutions to indebtedness of countries and governments are discussed. The Brady Plan, the Jubilee 2000 and the Heavily Indebted Poor Countries (HIPC) Initiative are also loan waiver options that have available to countries which were highly leveraged.
Loan Waivers: Housing Loans
Individuals avail of loans for various purposes including housing, financing of medical expenses, student loans, personal expenditures to buy electronic and household equipment. The most potent and burdensome of these are the housing loans and student loans. The Asian Crisis, the Sub-prime Crisis and the Euro Crisis, all saw excessive leveraging in favour of the real estate sector, the bursting of the real estate bubble and panic both among the borrowers and the lenders alike.
The Asian Crisis was preceded by a heady optimism in the Asian Miracle, a concept promoted by none other than the World Bank. The admix of capital account and financial sector liberalisation resulted in huge capital inflows. The not so well developed banking sector lent liberally, especially to the property sector. Data relating to exposure of banks to the property sector for 1998 indicates that it ranged from 15% to 25% in Korea and 40% to 55% in Hong Kong. Asset prices were on the rise initially and till then there were no worries. However, once the correction in asset prices began on account of slow overall economic growth there was pandemonium. It is pertinent to add here that in Hong Kong particularly, there has been a rise in property prices by 73% during 2010-13. The Hong Kong Monetary Authority has now placed a cap on the home loan amounts to cool of property prices to some extent. The subprime crisis in the US and the Euro crisis saw a sharp rise in the household leverage due to the steep rise in house pries as is evident from the Figure below.
The initial fall in price wiped out optimism in buyers, the consequent toughening credit-leverage resulted in lesser borrowing, forcing more sellers to hold the assets causing a further fall in the house prices, several times bigger. During and after the crisis ends, many businesses and individuals went bankrupt and unemployed, the economies were disrupted, and several businesses were on the verge of shutting down. The governments will then faced the choice of whom and at what cost to assist.
In its efforts to mitigate the crisis, the governments in all these economies have intervened in different ways, sometimes inefficiently. In all the above crises, the governments were supporting the financial sector by holding the federal funds rate near zero. Government bailouts, even if they were all for the public good, caused resentment from those who are not bailed out.
In America, over 4 to 7 million home loans were foreclosed as a result of the American mortgage crisis, and an estimated average of 20 million people thrown out of their homes for defaulting, double the number of people in Greece. The government in its efforts to help homeowners in some cases temporarily reduced their interest payments but this too failed. For subprime loans the loan to value ratio was 140% to 160% and the rate of new defaults was 7.4% per month by the end of 2009.
Reducing principal seems a better way to help homeowners and lenders and the country at the same time. John Geanakoplos from Yale University explains with an example. Consider a $160,000 subprime loan on a house that is now worth only $100,000. If the borrower loses his job or finds his earnings prospects are reduced, he will default. The lender will then end up with about $40,000. But if the loan is forgiven down to $90,000 both the lender and the borrower can be made better off. The borrower might choose to stay in his house and continue to pay the mortgage, or he might decide to sell the house as expeditiously as possible, returning $90,000 to the lender and pocketing the $10,000 himself. Either way the lender is better than the loss of $40,000 otherwise.
The example of Greece could explain the European scenario. Even when it was realised that Greece’s debts were unsustainable, the European Commission, the European Central Bank and the International Monetary Fund continued to lend Greece more money to pay the interest on the old debt, adding the new loans to the debt burden of the country. The slowdown in the GDP has led to a debt to GDP ratio for Greece of about 160%. The Greek have been protesting the ill effects of the austerity programs, while the German tax payer is angered that its government is lending the Greeks still more money when they know the old debt will not be repaid. Again here too if a part loan forgiveness along with some reforms was offered, the situation may have been better. A reform in the tax structure and education system could have along with a debt forgiveness been a better option. The German tax payer can accept that getting repaid half is better than a Greek collapse in which Germany does not get paid at all.
While offering a loan waiver on home loans it is necessary to divide buyers of housing into two different types. The first type is those who are genuine buyers for consumption of housing services, and the second are speculative investors. Buyers in the first category rent the houses they purchase to themselves and if the waiver is to be given it should be for this category. Buyers in the second group are those investing in housing as an asset for capital gains; they are mostly speculators and care should be taken to ensure that any gratis by the government or financial institution does not reach this group. Additionally selective credit control measures through the monetary policy by lending only for consumption demand would go a long way in reducing the bad debts in this sector. The squeeze on mortgage lending to speculators will discourage such borrowers but not borrowing for consumption demand thereby ensuring a more realistic asset price structure too.
The above analysis certainly does not preclude the fact that the financial sector must adopt prudential norms while disbursing loans. Excessive capital flows and the liberalisation in the financial sector caused the financial institutions to throw all caution to the winds and lend indiscriminately. The moral hazard created by the governments when loan waivers are offered could stimulate such indiscriminate lending.
Loan Waivers: Student Loans
Between 2000 and 2014, the total volume of outstanding federal student debt in the USA nearly quadrupled to surpass $1.1 trillion, the number of student loan borrowers more than doubled to 42 million, and default rates among recent student loan borrowers rose to their highest levels in twenty years. This increase in debt and default and more widespread concern about the effects of student loan debt on young Americans’ lives has contributed to a belief that there is a crisis in student loans. This data given by Adam Looney and Constantine Yannelis from the US Treasury and the Department of Economics, Stanford respectively suggest that there is a cause for concern. Moreover, the data shows that a larger number of students are borrowers from for-profit schools for 4 year programme and, to a lesser extent, 2-year institutions. It may be relevant to add here that the default in loans among borrowers for 4 year programmes in not for profit institutions is far lesser as the labour market is more favourable towards these student graduates.
Loan forgiveness in the US is covered under “Obama Student Loan Forgiveness” which is the popular name for a programme actually called the William D. Ford Direct Loan Program. If a borrower whose income is below a certain level owes $40,000 in Subsidized loans, the interest on this loan would normally be $229.17 per month, but the borrower would qualify for payment of $93.69. Thus $135.48 of interest per month is forgiven. If this persons financial situation does not change for three years, they would be forgiven $135.48 x 36 = $4,877.28. Again, there is a category known as the public service loan forgiveness. In the public service loan forgiveness program, you may qualify for forgiveness after 10 years or 120 payments instead of the standard 20-25 year forgiveness. This has been introduced so as to encourage people to opt for professions like teaching, police service etc within the ambit of public service which generally fetch lower salaries.
The moral hazard that the federally-backed loan program creates has resulted in some schools with the worst employment records for recent graduates have students with the highest levels of law school loan debt.
Push University survey suggests that, the average predicted debt on leaving university for UK students is £26,100 for those starting in 2011, rising to £53,400 for 2012 entrants. Also the average annual debts had risen 6.4% in the past year - more than inflation - to £5,680. This may be the result of students struggling to find part-time and temporary jobs because of the economic climate, as well as rising costs of expenses, such as travel and energy. Currently more than £10 billion is loaned to students each year. This is likely to grow rapidly over the new few years and the UK Government expected the value of outstanding loans to reach over £100 billion (2014-15 prices) in 2018 and continue to increase in real terms to around £330 billion (2014-15 prices) by the middle of this century.
Graduates will have to pay back their loans only once they start earning £21,000, and outstanding debt will be written off after 30 years.
In a new report by the Higher Education Policy Institute, UK, about 45p in each £1 lent is unpaid. Concerns have been growing for some time about the soaring cost of the loans, which cannot be recouped if students do not earn enough to meet the £21,000 repayment threshold, move overseas or return home to EU countries and become uncontactable.
Debt cancellation in general is welcome. Empirical data suggests that it is a better option to further loans being offered to offset the current ones even if at a lower rate of interest. This is a better solution when the economy is faced with unsustainable debt. What is definitely needed is prudence on the part of the lender to assess the credibility of the borrower. Stringent norms and strict self-supervision needs to be adopted by the financial sector so as not to lend excessively to a particular sector, which leaves it vulnerable in the event of a speculative attack or crisis.
Also, debt does not disappear. Taxpayers are burdened and it is generally seen that it leads to a problem of moral hazard. The story of the ant and the grasshopper is well known. The difference here is in the ending where the grasshopper in spite of its non thrifty attitude, gets by as the government waives off the loan burden. The traditional idea that the responsibility of a loan must fall upon those who borrow and lend has much truth.
Dr Radhika Lobo is Head, Department of Business Economics, Birla College of Arts, Science and Commerce. She has authored a book titled ‘Southeast Asian Crisis: An Economic Analysis’