Free-Market Economic Stimulus Proposal
Summary
Americans as a group have taken on too much debt that has led to significant economic problems. Mortgage debt increased from 66% of GDP in 2000 to 102% of GDP by the end of 2007. As real estate prices have fallen, much of this mortgage debt has become toxic and has led to significant liquidity problems in banking leading to a severe economic contraction world-wide. In an effort to reduce the overall debt load of Americans, help stop the fall in home prices and provided needed liquidity to the banking industry, a simple free-market solution is being proposed.
The proposal is to provide a one year window in which people are allowed to transfer money from a pre-tax retirement account (401K, IRA, or 403b) account without penalty at a flat tax rate of 15% directly toward payment on a mortgage.
Currently, there is a combined total of over $6 trillion located in 401K, IRA and 403b accounts. A 20% conversion of this money to pay toward mortgages would result in a ~$1 trillion liquidity injection into banks while reducing the federal deficit by ~$180 billion. The five key advantages of implementing this tax law change are:
1. It allows for a reduction in the overall debt load of Americans, specifically related to mortgage debt. $1 trillion in mortgage payments would reduce mortgage debt outstanding by 7% of GDP.
2. It provides liquidity to banks while reducing outstanding loan balances.
3. It also improves the financial position of the United States government. In addition to the initial 15% tax payments, it will eliminate/reduce the mortgage deduction for individual taxpayers going forward.
4. It provides cash to consumers. For those capable of paying off their mortgages from these funds, their disposable income rises sharply as their mortgage payment disappears.
5. For those without homes who have inadequate funds for a down payment but have pretax savings, this would allow them to access their existing personal funds toward the purchase of a home.
Existing plans to stimulate the economy typically attempt to boost the economy by increasing the federal debt load to inject money into the economy. The substitution of one type of debt (federal) for another (mortgage) does little to reduce America’s overall debt load.
2/23/09b
Problem Statement
From 2000-2007, the debt load carried by Americans rose sharply. The primary cause of this increase in debt load was mortgage debt. Mortgage debt rose from $6.3 trillion (66% of GDP) at the start of 2000 to $14.3 trillion (102% of GDP) at the start of 20081. Consumer debt from 3Q00 to 3Q08 increased by a much smaller amount – from $1.67 trillion (16.9% of GDP) to $2.58 trillion (17.9% of GDP) 2. The rise in mortgage debt helped fuel a rise in home prices. This phenomenon was not unique to the United States and multiple countries throughout the world experienced similar debt financed housing booms. Some others included Great Britain, Iceland, Spain, Australia, South Korea, Poland and Ireland3.
Many of these new mortgages were bundled into collateralized debt obligations (CDO’s) and sold to various financial institutions including banks, insurance companies, and pension funds. Lending standards were also relaxed in many cases such that people with poor credit histories, inadequate down payments, or inadequate income for the debt level were given mortgages. As home prices began to fall, many debtors started defaulting on their mortgage resulting in a sharp increase in home foreclosures. As more homes entered foreclosure and entered into forced sales, it further flooded the housing supply and lowered home prices leading to a popping of the home asset bubble.
As homeowners defaulted, banks and mortgage companies began to face losses on the CDO’s. To maintain capital ratios and provide liquidity, many banks began to sell their CDO holdings. With heavy selling and few buyers, CDO prices cratered and the investments became illiquid. This further stressed banks and financial companies. Overall liquidity dried up and spilled over into areas beyond the financial sector. Due to the credit crunch, many consumers and businesses reduced spending and a sharp economic contraction occurred. The contraction further reduced consumer confidence leading to a downward economic spiral.
Government responses to the crisis have typically involved borrowing money from the capital markets to inject liquidity into the banks or to consumers. Unfortunately, this has had limited success as governments and the private sector compete for the same capital.
Based on the problems listed above, a solution is needed that will allow multiple improvements to the financial system including:
- A reduction in mortgage debt outstanding.
- An improvement in liquidity for banks and financial institutions.
- A pricing improvement for the CDO’s
- A reduction in government deficits requiring money from the capital markets.
- A reduction in the excess inventory of homes to help stop the drop in home prices.
- An improvement in consumer confidence and willingness for consumers to spend and invest more.
Proposal
The proposal is to provide a one year window in which people are allowed to transfer money from a pre-tax retirement account (401K, IRA, or 403b) without penalty at a flat tax rate of 15% directly toward payment on a mortgage. The money would be paid directly from the retirement account to the mortgage holder with the 15% federal withholding taken out. It would be similar to a rollover of funds from a 401K to a rollover IRA. The money would not count toward an individual’s adjusted gross income.
Benefits of the proposal
While there is no way to be certain of the number of people who would participate in the proposed plan, assuming a 20% participation rate of IRA/401K/403b funds, approximately $1 trillion dollars of liquidity would be injected into the financial industry and approximately $250 billion would be paid to the federal government resulting in a reduction in the deficit. At the end of 2007, there was approximately $4.7 trillion in IRA’s and $4.5 trillion in defined contribution plans such as 401K and 403b plans for a total of $9.2 trillion4. Due to the market performance in 2008, the value of these investments has likely fallen to less than $7 trillion5. Even at the lower level, a significant amount of money is available for reducing the mortgage debt outstanding.
By reducing mortgage balances outstanding, it would also provide an improvement to the loan-to-capital ratio for banks. This is a key measure of bank health which has led to a number of bank failures.
The CDO’s which have become illiquid would also quickly increase in value and the injection of cash would speed up the cash payments from the CDO’s. The higher value of the CDO’s would also serve to improve the loan-to-capital ratio of the banks.
The plan would allow individuals who do not currently own a home but have money in a pre-tax account to be able to have adequate cash for a significant down payment or outright purchase. The current homeowner vacancy rate is 2.9% of homes6. Historically, this number is around 1.2%6. This means there is an inventory overhang of around 2 million homes that need to be sold to bring the supply and demand of homes back into balance. Until the surplus inventory of homes is sold, home prices will likely continue to drop. It would take about 3% of the people who have an IRA/401K/403b to purchase a new home to eliminate this inventory overhang.
The flat 15% tax on the withdrawal from the pre-tax accounts would also serve to improve the financial position of the U.S. government. During calendar 2008, federal debt to the public increased from $5.14 trillion to $6.37 trillion (+24%) 7. The $1.23 trillion dollar increase in debt to the public represents a significant draw on capital markets. In 2009, CBO federal deficit projection was $1.2 trillion prior to passage of the stimulus package8. A $180 billion dollar reduction in the federal deficit frees up the capital for other purposes within the economy. There is also a recurring benefit to the government as these people would no longer have mortgage interest to write off on their taxes.
On an individual level, those able to pay off mortgages would have more disposable income to use for spending or investing. From a consumer psychology perspective, the elimination of debt would eliminate much of the fear currently causing people to spend less. When you have no mortgage, you have no fear of losing your home.
Free Market Philosophy
As previously stated, mortgage debt rose from $6.3 trillion (66% of GDP) at the start of 2000 to $14.3 trillion (102% of GDP) at the start of 2008. At the same time mortgage debt was rising sharply, money at zero maturity (MZM) was also rising. MZM is money in savings, cash, checking and money market accounts that can be immediately liquidated. MZM rose from $4.3 trillion (46% of GDP) at the start of 2000 to $8.2 trillion (58% of GDP) at the end of 20079.
The obvious question is why have people been borrowing so much money at the same time they are increasing cash? I need to look no further than my own balance sheet to answer this question. I have both a mortgage on a house I purchased in 2003 and significant money market holdings in my 401K. Because of the existing tax laws, I am not willing to use my own cash in the 401K to pay off my debt. If I chose to use money in my 401K to pay off my mortgage, I would be subject to a) the regular income tax rate, b) a 10% tax penalty, c) a phase-out of child tax credits (5%), and d) a blackout period where I could not contribute to my 401K and the loss of my company matching funds. The incremental tax rate would exceed 50%.
The proposal is not a proposal to create new government regulations, but to temporarily suspend the existing penalties associated with a free movement of money.
The second reason that the proposal is consistent with a free market philosophy is that it does not eliminate “moral hazard.” Recent government actions on bank and mortgage bailouts have financially rewarded companies and individuals who made bad choices at the expense of those who made sound financial choices. With this proposal, individuals who took out NINJA loans (No Income, No Job or Assets) would not be financially rewarded at the expense of others. Likewise, those banks and mortgage companies who issued these loans would still be on the hook for their bad choices. Banks that followed sound market practices would be rewarded with the extra liquidity.
Potential Downside to Plan
There are three potential downsides I see to the plan:
First, the liquidation of $1.2 trillion in assets in 401K/IRA/403b plans could potentially create downward pressure on stock prices. About 50% of existing holdings in these plans are domestic equity funds4. The remaining 50% is in international funds, bond funds, money market funds, and balanced funds. While $600 billion is a significant withdrawal from the stock market, it is equivalent to the amount that was injected in the S&P 500 in 2007 through stock buybacks10. The $589 billion in 2007 only had a minor impact on the stock market values with the S&P500 index only gaining 3.5%.
There are also adequate funds on the sidelines to purchase these shares. Money at Zero Maturity has increase by $1.2 trillion since the start of 20089. Any dip in stock prices due to the liquidations should be limited in duration.
The second downside that may be mentioned is that this plan reduces retirement savings as people reduce 401K/IRA/403b accounts. While this is technically a true statement, a free and clear home is a significant retirement asset. A retiree with no mortgage needs less money on a monthly basis. If needed, a free and clear home provides a retiree an asset that can be sold or produce income through a reverse mortgage.
The third complaint that may exist is that such a plan would be bad for the mutual fund industry. A 20% withdrawal of assets from these plans would significantly reduce revenue (-20%) for mutual fund management companies. While this is a true statement, government policy should not support these companies at the expense of the individual holders of these assets or the economy at large.
Data Sources
Any questions or comments about the proposal can be sent to:
Charles Musick
Data references to follow.
- Mortgage debt source: Federal Reserve (http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf) Table L2, Row 10 GDP Data Source: Bureau of Economic Analysis: http://www.bea.gov/national/index.htm
- Consumer Debt Data source: Federal Reserve: http://www.federalreserve.gov/releases/G19/Current/ GDP data source: Bureau of Economic Analysis: http://www.bea.gov/national/index.htm
- Other Countries with real estate bubbles Source: Wikipedia: http://en.wikipedia.org/wiki/Housing_bubble
- 2008 ICI Factbook: http://www.icifactbook.org/fb_sec7.html#7.1
- 27% drop in average balances from L.A. Times: http://latimesblogs.latimes.com/money_co/2009/01/401k-wall-stree.html
- U.S. Census Bureau data: http://www.census.gov/hhes/www/housing/hvs/qtr408/q408ind.html
- U.S. Treasury Department: http://www.treasurydirect.gov/NP/BPDLogin?application=np
- Congressional Budget Office: http://www.cbo.gov/doc.cfm?index=9957
- Money at Zero Maturity Date from St. Louis Fed: http://research.stlouisfed.org/fred2/series/MZM GDP: http://www.bea.gov/national/index.htm
- Forbes Magazine: http://www.snl.com/snlitn/scans/052008increfor.pdf
