More on why the Swedish Model works to end a bank solvency led financial crisis

The Washington Post reports on a paper that looks at the impact that underwater mortgages had on the economy.

The paper concludes that the benefit to the economy to be gained from writing down the mortgage debt more than offsets the cost to the creditor from realizing the loss.

Regular readers will recall that under the Swedish Model banks are required to recognize upfront the losses on the excess debt in the financial system.  An example of the loss that could be realized is the difference between the outstanding mortgage balance and the value of the house.

A recently revised paper by Atif Mian of Princeton, Amir Sufi of the University of Chicago Booth School of Business and Kamalesh Rao of MasterCard Advisers suggests that underwater mortgages have played a significant role in holding back the recovery. 

The paper, “Household Balance Sheets, Consumption and the Economic Slump,” was first released several years ago, but it has been revised to include an important new calculation. 

It is widely recognized that the fall in housing prices had a “wealth effect” that led homeowners across the country to cut back on spending. 

In the updated paper, Mian, Sufi and Rao measured how much more underwater borrowers probably cut back on spending compared to borrowers without an overhang of mortgage debt. (More precisely, they measured how much homeowners cut back on auto spending for each dollar loss of housing wealth. But that’s important; the decline in auto sales was a significant part of the economic contraction.) 

The authors found that being underwater makes a big difference. .... 

In an e-mail interview, Sufi says he and his co-authors believe the paper is the first to show that borrowers with very high leverage – which would include people who are underwater – are likely to cut back significantly on spending in a housing decline....

Sufi says the findings underscore the notion that principal reductions – reducing the overhang of mortgage debt left by the financial crisis – should have been more widely embraced as part of the policy response to the housing bust. 

“Facilitating mortgage debt write­-downs would have softened the blow to household spending. A dollar lost by a creditor has less of a negative effect on consumption than the positive effect on consumption from a dollar gained by an underwater homeowner,” he says.