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Efficient Credit Policies in a Housing Debt Crisis, Brookings Papers on Economic Activity


Consumption, income, and home prices fell simultaneously during the financial crisis, compounding recessionary conditions with liquidity constraints and mortgage distress. We develop a framework to guide government policy in response to a crisis, where government may intervene to support distressed mortgages. Our results emphasize three aspects of efficient mortgage modifications. First, when households are borrowing constrained, government resources should support household liquidity up-front. This implies loan modifications that reduce payments during the crisis, rather than using government resources to reduce payments over the life of the mortgage contract, such as via debt reduction. Second, while governments will not find it efficient to directly write down borrower debt, in many cases it will be in the best interest of lenders to write down debt. Reducing debt is effective in reducing strategic default. Lenders, who bear credit default risk, have a direct incentive to write down debt and avoid losses due to default. Finally, a well-designed mortgage contract should take these considerations into account, reducing payments during recessions and reducing debt when home prices fall. We propose an automatic stabilizer mortgage contract which does both, by refinancing mortgages into lower-rate adjustable rate mortgages when interest rates fall during a downturn -- reducing payments and lowering the present value of borrowers' debt.




Janice C. Eberly, Arvind Krishnamurthy

Date Published



Eberly, Janice C., and Arvind Krishnamurthy. 2014. Efficient Credit Policies in a Housing Debt Crisis. Brookings Papers on Economic Activity.


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