We need a fair system for restructuring debt

Since the beginning of the financial crisis, your humble blogger has predicted that the global economy will not recover until creditors recognize their losses on the debt in the financial system that will never be repaid.

Embedded in this prediction is the notion that a fair system can be developed for rapidly restructuring this debt.

The closest we have come to a fair system for rapidly restructuring debt is Iceland.

Iceland adopted the Swedish Model for handling a bank solvency led financial crisis and required its banks to recognize upfront the losses on the excess debt.

Specifically, the banks had to write down the value of their loans to a level where the borrower could afford the repayment.  Affordability was based on standards like limiting debt payments to 35% of gross income.

However, there were limits placed on this write down.

Specifically, if an independent third party would pay more for the asset collateralizing the loan than the supportable loan amount, the banks only had to write down the loans to this level.  This meant the write down was limited so that it would not create any equity for the borrower.

On the surface, this system for restructuring appears fair.

The creditor takes responsibility for the portion of the loan that exceeds the borrower's capacity to repay.  This is as it should be as the creditor is suppose to evaluate the borrower's repayment capacity and not extend debt in excess of this level.

The borrower takes responsibility for paying what they can afford.  They cannot simply walk away from the debt.

Please note that this system for restructuring debt could be applied to sovereigns as well as to individuals and companies.

In an interesting column, Joseph Stiglitz argues that a fair system for restructuring sovereign debt is needed.

In debt crises, blame tends to fall on the debtors. They borrowed too much. 

But the creditors are equally to blame – they lent too much and imprudently. 

Indeed, lenders are supposed to be experts on risk management and assessment, and in that sense, the onus should be on them. 

The risk of default or debt restructuring induces creditors to be more careful in their lending decisions.