McKinsey & Co takes an indepth look at possible new approaches to deleveraging, plus managing and monitoring debt in a debt saturated world

 By Gareth Vaughan

Could the likes of continuous workout mortgages that adapt to changing conditions, shared responsibility mortgages, US style non-recourse mortgages, reduced tax incentives for debt, and greater use of macro-prudential tools such as the Reserve Bank's loan-to-value ratio (LVR) restrictions be the answer to a world awash with debt?

These are among potential solutions touted by consultants McKinsey & Company in a sobering and in parts frightening report entitled Debt and (not much) deleveraging. The report ought to be recommended reading to anyone wondering why the global economy continues to puff and pant its way out of the quagmire stemming from the cataclysmic events of 2008.

McKinsey looks at 47 countries (not including New Zealand) seven years on from the onset of the Global Financial Crisis (GFC) and finds deleveraging is limited to a handful of sectors in some countries, and that debt to GDP is now higher in most places that it was before the GFC. McKinsey says between 2007 and the second quarter of 2014 global debt grew by US$57 trillion, or 40%, to US$199 trillion.

"Not only has government debt continued to rise, but so have household and corporate debt in many countries. China’s total debt, as a percentage of GDP, now exceeds that of the United States. Higher levels of debt pose questions about financial stability and whether some countries face the risk of a crisis. One bright spot is that the financial sector has deleveraged and that many of the riskiest forms of shadow banking are in retreat," McKinsey says.

"But overall this research paints a picture of a world where debt has reached new levels despite the pain of the financial crisis. This reality calls for fresh approaches to reduce the risk of debt crises, repair the damage that debt crises incur, and build stable financial systems that can finance companies and fund economic growth without the devastating boom-bust cycles we have seen in the past."

'Strong correlation between increases in real estate prices & household debt'

Noting that unsustainable levels of household debt were at the epicentre of the GFC in 2008, McKinsey says seven of the 47 countries in its report have potential vulnerabilities in household debt including Australia. Although NZ's not included in the McKinsey report, the Lafferty Group recently put NZ's total consumer credit to personal disposable income ratio at 164%, with only Canada higher across a range of other countries at 166%. 

Credit rating agency Fitch recently pointed out NZ household debt had risen to 156% of disposable income from 152% in 2011 and is "high" by international standards. And Reserve Bank sector credit data shows NZ total household claims up $36.6 billion, or 21%, to $211.5 billion in the six years to December 2014.

"More than ever, effective tools are needed for issuing, monitoring and managing household debt," says McKinsey.

The firm points out mortgages are the main form of household debt in all advanced economies, with rising house prices contributing to more borrowing.

"And, when buyers can obtain larger mortgages, they bid up house prices even more. We find a strong correlation between increases in real estate prices and household debt both across countries and between US states."

McKinsey then goes on to describe a situation which neatly summarises ongoing issues here in NZ in relation to the Auckland housing market.

"Housing prices, in turn reflect land costs, which are influenced by physical limitations, regulatory policies and urban concentration. We show that urbanisation patterns matter: countries in which a large share of the population crowds into a small number of cities have higher real estate prices - and household debt - than countries with more dispersed urban development. Policy makers will therefore need to be particularly vigilant in monitoring debt growth and sustainability in global cities with high real estate prices," McKinsey says.

Learning to live with debt

In a section of the report entitled Learning to live with debt, McKinsey notes effectively managing the growth of debt, and reducing it where necessary, is an imperative. Here it throws up several ideas to mull including;

1) Encourage innovation in mortgage contracts;

2) Improve processes for private sector debt restructuring;

3) Use macro-prudential tools to dampen credit cycles;

4) Reduce tax incentives for debt;

5) Consider a broader range of tools for resolving sovereign debt;

6) Improve data collection and monitoring of debt;

7) Create a healthy mix of bank and non-bank credit sources. And;

8) Promote financial deepening in developing economies.

In terms of 1) McKinsey points out that how debt contracts are written matters a great deal. It says innovations in mortgage contracts would require action by the private sector, but public policy might be needed to enable and encourage such a development.

"One approach would be to include an insurance element in debt contracts, making automatic adjustments in repayment schedules contingent upon specific events, such as job loss or indicators of economic recession and rising unemployment. Economist Robert J. Shiller has proposed creation of 'continuous workout mortgages,' which are structured to adapt to changing conditions - in the economy or the household - over the course of a loan to keep payments at a level that the borrower can afford," McKinsey says.

"In such mortgages, changes in the monthly payment, and in the mortgage balance, could be triggered by events such as a significant changes in home prices, job loss, or recession. Payments would revert to the original level when conditions improve. The continuous workout mortgage would reduce the need for borrowers to exercise the costly option of default to alleviate debt and would guarantee lenders a stream of continuous payments, while sharing the underlying risk with the borrower."

"The automatic adjustment mechanisms of the mortgage would avoid costly, and possibly repeated, negotiations between borrowers and lenders."

The effectiveness of this approach would depend on the level of participation, McKinsey says, with contracts voluntary and both borrowers and lenders understanding their commitments at the time of signing.

"However, many borrowers might be disinclined to pay for such insurance, particularly during boom times. In the interest of financial system stability, policy makers could, if they chose, create tax incentives for such mortgages. There are precedents for such flexibility in other types of debt contracts. For example, in the United Kingdom and Australia, student loan payments are capped at a certain percentage of the borrower’s income, so that payments rise along with incomes," says McKinsey.

Lenders, borrowers sharing upside and downside of property prices

Another approach could be the introduction of an equity-like element of risk sharing into a house purchase.

"For instance, economists Atif Mian and Amir Sufi have suggested 'shared responsibility' mortgages, in which lenders and borrowers alike face the upside and downside of fluctuating real estate prices. If home prices in the surrounding community decline below the purchase price of the home, the borrower’s payment is reduced by a similar percentage. When prices recover, the payments revert to the original rate and the lender is entitled to 5% of the capital gain when the borrower sells," McKinsey says.

"The objective is to avoid foreclosure by automatically adjusting loan payments during tough economic conditions."

 One obvious challenge to the implementation of risk-sharing features in mortgage contracts is moral hazard, McKinsey adds. Furthermore interest rates on such loans would probably be higher than on conventional loans, given extra risk taken by the lender.

"However, important positive externalities accrue to the broader economy and surrounding community: avoiding forced sales of homes and associated litigation, as well as degradation of properties and neighbourhood blight, which can lead to additional losses for mortgage lenders and other homeowners."

'Non‑recourse loans can lessen the severity of a recession'

On 2), McKinsey puts the spotlight on the recourse mortgages that are the norm in countries such as NZ, and US style non-recourse mortgages. It notes recourse mortgages give creditors strong protection making it hard for borrowers to walk away from their housing debt. Borrowers are thus incentivised to avoid excessive leverage and continue to make loan repayments under all circumstances.

"From an economic perspective, however, recourse loans have the unwanted effect of deepening recessions, by forcing struggling households to make loan repayments even if it requires sharply reducing consumption," says McKinsey.

"By allowing overly indebted borrowers to default and extinguish their debts, non‑recourse loans can lessen the severity of a recession and aid recovery by enabling households to reestablish themselves in less expensive housing and quickly resume normal consumption."

It points out in a non-recourse mortgage creditors can seize only the collateral that secures the loan in the event of default and the debt is then extinguished for borrowers.

"While mortgage defaults cause pain for both banks and homeowners, they enable rapid write-downs of debt and they share risk between creditors and borrowers...US household debt fell by 26 percentage points from 2007 to the second quarter of 2014 largely because of mortgage rules that allowed borrowers to default and walk away from debt."

McKinsey does note the impact of the bank’s loss could inhibit new lending. But it goes on to say household deleveraging happens fastest in countries with non‑recourse mortgages, such as the US, thus clearing the way for economic recovery.

The firm also notes, however, drawbacks of non‑recourse mortgages include they can encourage borrowers to take on more debt, especially during a housing boom, because people know they can walk away from the debt if necessary. And that borrowers can choose to default, even if they can afford loan repayments, if the value of their house drops below the value of the mortgage.

"To counter the incentive to borrow too much, non‑recourse mortgages could be combined with conservative limits on loan-to-value ratios and counter cyclical macro-prudential rules to dampen new lending during credit booms," says McKinsey.

The old chestnut of property & tax

In terms of 3), McKinsey notes macro-prudential tools such as the Reserve Bank "speed limit" on banks' high LVR residential mortgages are focused on financial system stability. But it says they could also take into account total leverage in an economy.

"When total debt in a country is high relative to income, individual loans that may be prudent in other situations can contribute significantly to systemic risk. Assessing a broad range of indicators when applying macro-prudential policies is warranted."

On 4) McKinsey suggests tax preferences for debt, especially for residential property mortgages, are deserving of public discussion. Real estate incentives such as tax deductability of mortgage interest and preferential treatment of capital gains on residential property can encourage wealthy households to leverage high cost homes to maximise tax benefits.

"Policy makers can therefore reconsider the mix of incentives provided for residential housing and balance the social goal of home ownership against other needs, such as investments in infrastructure, education, or research and development that would enhance the long-term productive capacity of the economy. Reducing or phasing out some of the incentives should be debated," McKinsey says.

The charts below both come from the McKinsey report.

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