Flexible repayment options for debt: Is liquidity or solvency the issue?

In a column last week for the New York Times Magazine, Binyamin Appelbaum asks if subprime mortgages are ready for a redo in the U.S. economy, noting that mortgage-lending standards today are as strict as they were more than a decade ago—well before the outrageous excesses of the subprime lending boom got underway. Before Appelbaum’s question can be answered, though, economists and policymakers may want to consider making all mortgages safer before increasing the supply of them.

A paper released last week by the Brookings Papers on Economic Activity by economists Janice Eberly of Northwestern University and Arvind Krishnamurthy of Stanford University offers one such proposal. Their plan, simply put, would allow for the automatic reduction of monthly mortgage payments should housing prices decline, which would allow a borrower to better handle the payments in the short term. Importantly, the total amount of the mortgage wouldn’t decline. Payments for the mortgage would rather be spread over time so that the borrower can better handle them in times of economic distress.

This plan may not be the best course for all situations, but in contrast with another plan it offers a new way to think about debt and policy responses to indebtedness. That other plan comes courtesy of economists Atif Mian, of Princeton University and Amir Sufi, of the University of Chicago. Their plan calls for what they call “shared responsibility mortgages.” These mortgages would allow for automatic decreases in payments, based on local housing prices, but keeping the length of the mortgage the same. The result would be reduction in the principal of the mortgage.

The two plans both call for automatic reduction in payments, but their underlying diagnoses are very different. FT Alphaville’s Matthew C. Klein points out that the difference is whether the economists believe the homeowners are having a liquidity problem (their home investment is sound, but they are just having temporary trouble making payments) or a solvency problem (the mortgage payments relative to the value of the house exceed the long-term earnings potential of the borrower).

If you believe the issue is liquidity then the Eberly-Krishnamurthy plan makes sense. In this case, distressed homeowners might have lost jobs and need some time to get back on their feet. But if solvency is the concern then the Mian-Sufi plan is more appropriate. This scenario would address the bursting of a large housing bubble that results in millions of homeowners being underwater on their mortgages—paying more for their homes than they are worth—through no fault of their own.

This analysis doesn’t stop just at the mortgage market. Think of student loans. If you believe that higher education will pay off for a vast majority of students then you may want student loan payments to vary overtime as young workers wait for raises but not let the total amount of the loan decrease. But if you are skeptical about the return on investment of the education itself then you may want to allow for principal reduction by keeping the time of payback constant but payments varying.

But at their heart, both of these proposals would make debt contracts more flexible. The plans vary in degree, but all four economists acknowledge that inflexible debt contracts are dangerous for families and pose a wider economic risk. Weaning our economy off debt can help improve the fortunes of U.S. families and economic stability.