Financial Crises
Chapter

Chapter 17. Principles of Household Debt Restructuring

Author(s):
Stijn Claessens, Ayhan Kose, Luc Laeven, and Fabian Valencia
Published Date:
February 2014
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Author(s)
Luc Laeven and Thomas Laryea The authors thank Jochen Andritzky, Tam Bayoumi, Olivier Blanchard, Stijn Claessens, Luis Cortavarria-Checkley, Giovanni Dell’Ariccia, Karl Driessen, Sean Hagan, Antonio Ignacio Garcia Pascual, David Hoelscher, Yan Liu, Mauro Mecagni, James Morsink, Martin Muhleisen, Ceyla Pazarbasioglu, Catriona Purfield, Nadia Rendak, Guillermo Tolosa, Fabián Valencia, Tessa van der Willigen, Johannes Wiegand, and members of the interdepartmental Debt Restructuring Working Group for helpful discussions and comments.

Household indebtedness reached historically high and likely unsustainable levels in several countries hit by the 2007–09 financial crisis (Figure 17.1). In some countries the indebtedness stemmed from excessive credit booms in the run-up to the crisis, and was exacerbated by sharp declines in house prices. In other countries, where foreign-currency-denominated loans were prevalent, it was also the result of a balance sheet effect triggered by currency depreciation.

Figure 17.1Household Indebtedness in 2000 and 2006

Sources: Organization for Economic Co-operation and Development statistics; and IMF staff calculations.

Household debt overhang and debt-servicing problems feed into different but connected downward spirals.1 First, they weaken bank balance sheets through an increase in nonperforming loans, which, in turn, may lead to a reduction in credit availability, putting further pressure on house prices and prices of other asset classes. The resulting decrease in wealth and collateral value further worsens the household debt problem. Second, household debt problems can negatively affect consumption, which may turn into lower growth and higher unemployment, compressing household income and further feeding into both downward spirals.

At times of financial crisis, governments often contemplate debt restructuring to deal with social problems that arise when households are no longer able to repay their loans. These problems can be particularly pronounced when the distressed debt involves household mortgage loans (Figure 17.2). Although governments with fiscal space may decide to pursue restructuring policies on the basis of social considerations, the design of such debt-restructuring programs should be based on sound economic principles.

Figure 17.2Household Mortgage Indebtedness in 1996 and 2006

Sources: Organization for Economic Co-operation and Development statistics; and IMF staff calculations.

This chapter assesses the case for government intervention in household debt restructuring and proposes a template for a household debt-restructuring program that could be adapted to individual country circumstances.2

The Case for Government Intervention

Resolving the debt overhang problem requires the economy as a whole to bear some costs associated with the resolution of distressed loans. The purpose of policy is to minimize the inefficiencies associated with resolving the problem. Any government intervention will involve distortions; however, the question is whether the benefits of intervention exceed its costs. Moreover, if intervention involves government financing, the extent of intervention should be constrained by the degree of fiscal space available and the potential negative impact of the intervention on public debt sustainability.

Two sets of issues may interfere with a market-driven solution and can justify more proactive policy than simply letting the courts and normal bankruptcy procedures, together with voluntary loan workouts, attempt to address the problem. First, a crisis affecting the household sector, such as the one faced by a number of countries in 2007–09, may involve a very large number of bankruptcy cases—even larger in absolute numbers than corporate sector bankruptcies. A timely resolution of these bankruptcies through the court system would not be feasible even for countries with the highest institutional capacity and the most efficient legal systems (Table 17.1).3 Additionally, voluntary loan workouts can give rise to attrition problems, with delays that are optimal for the individual negotiators but not for the economy as a whole. Delays and the potential gridlock problems of market-driven solutions, the legal costs involved, and the associated destruction of wealth call for a more organized resolution strategy.

Table 17.1Cost of Corporate Bankruptcy Proceedings in Selected Economies, 2009
CountryTime (years)Cost (percent of estate)Recovery rate (cents on the dollar)
Argentina2.812.029.8
Austria1.118.071.5
Brazil4.012.017.1
Bulgaria3.39.032.1
Estonia3.09.037.5
France1.99.044.7
Germany1.28.052.2
Hungary2.015.038.4
Iceland1.04.076.6
Italy1.822.056.6
Japan0.64.092.5
Latvia3.013.029.0
Lithuania1.77.048.0
Romania3.39.029.5
Spain1.015.073.2
Sweden2.09.075.1
Thailand2.736.042.4
Turkey3.315.020.2
Ukraine2.942.09.1
United Kingdom1.06.084.2
United States1.57.076.7
Source: World Bank Doing Business database, 2009.Note: This table summarizes weaknesses in existing corporate bankruptcy law and the main procedural and administrative bottlenecks in the bankruptcy process. Data are based on a prototype firm (a hotel) and refer to bankruptcy proceedings for firms rather than households.
Source: World Bank Doing Business database, 2009.Note: This table summarizes weaknesses in existing corporate bankruptcy law and the main procedural and administrative bottlenecks in the bankruptcy process. Data are based on a prototype firm (a hotel) and refer to bankruptcy proceedings for firms rather than households.

Household debt restructuring can also be warranted to address the externalities that arise when massive loan defaults by households result in unnecessary and costly liquidations, including foreclosures on real estate. These problems are particularly severe when homeowners possess negative equity in their homes. Although financial institutions initiated voluntary restructuring schemes in several countries (e.g., Lithuania, Mexico, and the United States4) to avoid collateral execution, financial institutions do not fully internalize the negative externalities generated by such unnecessary liquidations. House prices will not stabilize so long as there is an expectation of continuing house price deflation, exacerbated by widespread foreclosures. In addition, foreclosures can have a negative effect on neighborhood values. Essentially, this can be seen as a multiple equilibria situation: in one equilibrium, debt overhang is resolved more rapidly, leading to stabilization of house prices and resumption of growth; in the other, debt overhang lingers, resulting in further declines in house prices and contributing to a worsening of the recession.

In addition to taking into account the capacity of the legal and institutional system to handle wide-scale, case-by-case restructuring, the argument for government intervention depends on the dimension of the debt problem, both from the perspective of the debtors (households) and the creditors (banks). If the scale of distressed household debt is relatively small or banks are sufficiently sound, coordination problems are not overwhelming, and foreclosures are not widespread enough to create significant negative externalities, then the problem can be left to private sector borrower-creditor debt renegotiations. Box 17.1 summarizes some operational guidelines for assessing the scale of the problem. Government intervention is needed when both the scale of distressed household debt is sufficiently large to have macro implications and banks in distress are paralyzed by insufficient capital to absorb expected losses, lack of internal capacity to carry out individualized restructurings, or by coordination failures. The capacity of the legal and institutional framework to support individualized restructuring will also be a factor informing government intervention.

Box 17.1Assessing the Size of the Problem: Some Operational Suggestions

A practical issue in deciding whether household debt restructuring may be needed is determining how to assess the size of the problem. This exercise involves collecting and analyzing data on several possible dimensions of distressed household debt.

Current picture. A comprehensive assessment requires information on the outstanding amount of nonperforming (gross) household debt, both in nominal terms and as a percentage of the total loan portfolio of banks, as well as data on that debt by type of credit (mortgages, credit cards, car loans, and other consumer credit), currency, amounts and number of days past due, and collateral values (accounting values according to the bank records). These stock data statically frame the problem, allowing it to be usefully compared with the broader picture of all household debt, whether performing or nonperforming. In addition, if data are available, indicators such as loan-to-value (LTV) ratios, loan-to-disposable income (LTDI) ratios, and original and current debt-service-to-disposable-income may allow household borrowers to be grouped according to their current financial condition.

Evolution over time. The transition in credit quality for household claims in distress, that is, how quickly household debt is deteriorating from “watch status” to the various nonperforming categories (substandard, doubtful, and loss), based on the length of time loans are overdue, must be assessed. The trend over time of total household debt in distress (in absolute amounts and appropriately scaled) and the evolution of the shares of debt in different credit quality categories (particularly the incidence of “loss” credits) allows an assessment to be made of whether the problem is becoming wider and deeper, or may become so in the future, or is instead relatively stable. In addition, information on real estate prices may help determine to what extent “negative equity” (an LTV ratio greater than one) of mortgage loans is, or is expected to become, a problem for household borrowers and lenders. However, it should be kept in mind that the definition of nonperforming loan categories may differ somewhat across countries. In addition, in crisis situations with rapidly rising unemployment and falling house prices, past trends may be a poor guide for future developments.

Distribution across financial institutions. Of immediate interest, from both a financial stability and a contingent liability standpoint, is how concentrated the problem is among individual banks. At least two dimensions matter. The first dimension is whether the institutions most affected are those that play a systemic role in the payments and settlement system, or in other key financial segments such as the interbank market in which exposures could act as a channel for further spillover effects. The second dimension is whether the institutions affected have enough cushion—provisions, loan loss reserves, and overall capitalization—to absorb the losses without violating prudential capital requirements or other supervisory norms that would trigger corrective action.

Impact on financial institutions. The impact of restructuring strategies on the financial institutions must be gauged. This evaluation requires, for example, determining the likely impact of reduced rates or lengthened maturities for distressed claims undergoing restructuring on financial institutions’ cash flows, liquidity, and earnings. Similar exercises would involve assessing the impact of additional provisioning on profitability and capitalization of the institutions most affected, and the dependence of their earnings on continued household debt service. These exercises are typically conducted in collaboration with banking experts, the supervisory authorities, and the involved lending institutions.

Note: This box was prepared primarily by Mauro Mecagni (IMF, Strategy, Policy, and Review Department).

Whether government intervention in the form of financial support is feasible and credible depends on its impact on public debt sustainability and the available fiscal space. If government bank-recapitalization programs are also envisaged, authorities need to consider any overlap between the costs of debt restructuring and the costs of bank recapitalization when assessing the impact of government intervention on public debt. Debt restructuring, by generating writedowns in asset values on banks’ balance sheets, will negatively affect the capital position of banks, and will thus most likely have to be accompanied by a bank recapitalization program. Such a recapitalization program will need to be calibrated in the amount necessary to bring the banks back to solvency after debt restructuring.

Design of Government Intervention in Household Debt Restructuring

When considering the extent and nature of government intervention in household debt restructuring, two broad approaches, which are not mutually exclusive, can be envisioned.

Under the first approach, the government establishes the legal and institutional framework that supports case-by-case restructuring. If operation of the framework is sufficiently predictable, the process will also catalyze restructurings that take place out of court. A reasonably effective legal system for credit enforcement, including through foreclosure, is necessary to support extension of credit in the economy and to bring debtors to the negotiating table if restructuring is warranted. However, the wealth destruction and extreme liquidity pressures that can arise in systemic crises can be exacerbated by wide-scale resort to credit enforcement measures. In particular, as discussed above, widespread foreclosure of mortgaged property can further depress house prices. Therefore, it is important that an effective court-supervised insolvency framework be in place for individual debtors, providing for multicreditor restructuring through the following key legal features: (1) an automatic stay on creditor enforcement and debtor payments should be enforced during the insolvency proceedings; (2) if the debt is secured, but the market value of the collateral (including the value of the household property securing a mortgage) is below the value of the loan, the court has the power to restructure the amount of the deficiency as unsecured debt; (3) the modification of loan terms should take into account the payment capacity of the debtor; and (4) a “fresh start” should be provided through discharge of financially responsible debtors from the liability for unsustainable debts at the end of the liquidation or rehabilitation period.5

Case-by-case debt renegotiations between creditors and debtors can result in an adjustment in loans on a voluntary basis to reduce debt payments through some combination of interest rate reductions, principal amount reductions, and maturity extensions. These three methods of debt reduction are often mixed to improve incentives for both lenders and borrowers to participate. For example, interest rate reductions alone, while attractive for the borrower, may severely reduce the cash flow position of the lender. Maturity extensions allow the adverse impact on the cash flow of the lender to be spread over a longer period, thereby making interest rate reductions more affordable to the lender. In addition to putting in place the relevant legal and institutional framework, the government can play an important role in facilitating case-by-case workouts by creating proper incentives and removing impediments to loan restructuring. For example, government can enhance participation by supporting nonbinding guidelines for private-sector-led restructuring.

A second approach involves the establishment of a government-sponsored debt-restructuring program that includes some form of financial support. Such a program could cover a certain group of borrowers or loans, or could include all loans.6 Government support could take a multitude of forms. The government could provide financial support to the banks that restructure household loans, or it could establish a separate asset management company to purchase and resolve distressed assets. Furthermore, the government can provide direct support to the households through some form of subsidy, such as debt forgiveness, interest or exchange rate subsidies, or tax incentives.

When household debt overhang is widespread and severe, and the capacity of the banking system to restructure loans is limited, voluntary workouts that rely on case-by-case restructuring of loans become a less attractive option, making a comprehensive debt-restructuring program a more effective approach. At the same time, comprehensive debt-restructuring programs risk being too generous by offering restructuring to borrowers who would have been able and willing to make payments on their debt without restructuring. Ideally, debt-restructuring programs should be designed to lead to a “separating equilibrium” in which only borrowers that are unable to repay their debt take advantage of the program. The degree of government intervention depends on the scale of the problem, the ability of debtors and creditors to absorb losses, and the fiscal space of the government.

Any government-sponsored debt-restructuring program should help restore the viability of individual borrowers while minimizing the direct fiscal cost, reducing the risk of bank failures, and establishing the basis for the recovery of the real sector. These multiple goals may not be fully compatible, and policy choices may need to be made about where to strike the balance. The design of a debt-restructuring program should incorporate a number of basic features:7

  • Objective. The primary objective is to turn troubled loans into performing loans, while mitigating the moral hazard created by offering debtors the opportunity to not repay on the loan’s original terms. The program could be directed to reducing the debt-service requirements of borrowers who have experienced increases in their scheduled loan repayments as a result of adverse interest rate or foreign exchange rate shocks, or to address the buildup of a substantial amount of nonperforming loans.

  • Scope. The program should, where feasible, be selective and target borrowers who cannot meet their debt-service obligations but whose ability to service their debt is likely to be restored upon restructuring. The restructuring program could be designed to compensate the targeted group of borrowers either partially or in full—but in any case at a sufficient level to restore sustainable debt levels and the servicing capacity of borrowers. Defining criteria for such selectivity and reliably applying the criteria could be a major challenge, especially if data are unreliable and political or social considerations are pressing factors. Public funding, if used, would need to be sufficient to cover all qualifying participants. Conversely, the scope of the program could be subject to the public funding envelope.

  • Proportionality. The degree of government intervention in the program should depend on the scale of the problem, the capacity of creditors and debtors to absorb losses, and the fiscal space of the government. Intervention should not impinge on government debt sustainability, and burden sharing between creditors and debtors should depend on their ability to absorb losses.

  • Participation. Participation should be on a voluntary basis. Banks should be induced, not forced, to restructure their debts with borrowers.8 Compulsory restructuring, outside of the court-supervised insolvency process, will give rise to legal challenges and should be avoided.9

  • Simplicity. Given the large number of loans involved in household debt restructuring, program design should be based on simple rules and verifiable information to speed up restructuring and reduce the potential for abuse. These rules should be based on analysis of the structure of banks’ household loan portfolios. If it is not available already, banks will need to share with the government the necessary information to conduct such analysis should public funds be used to support the program.

  • Transparency and accountability. The program should include mechanisms that allow the authorities to monitor restructuring progress to ensure the accountability of the program participants, and to make adjustments to the program if necessary. Mechanisms such as ongoing reporting and audit requirements are especially important if public funds are used because they would help safeguard the integrity of the program and make the most effective use of taxpayer money.

Implementing A Government-Sponsored Debt-Restructuring Program

Before embarking on a government-sponsored debt-restructuring program for the household sector, several factors must be taken into account, including ongoing efforts to restructure loans by banks and the dynamic impact on the quality of banks’ loan portfolios. Close coordination with key market players may help to identify the need for and size of public intervention. Also, loan restructuring could set perverse incentives for borrowers in the future, negatively affecting the level of nonperforming assets. To avoid multiple rounds of debt restructuring, government-sponsored debt-restructuring programs should generally not be introduced before macroeconomic policies have stabilized the economy and a bank recapitalization program has been put in place to restore the banking sector to health, taking into account prospective losses from debt restructuring. Debt restructuring should not be regarded as an instrument that can displace sound macroeconomic policies.

The advantage of a restructuring program that provides systematic loan modifications for a large pool of borrowers is that it offers a streamlined approach that can take advantage of economies of scale. Economies of scale reduce coordination costs, thereby enhancing participation by a large number of banks and borrowers. At the same time, it should be realized that any debt relief generates moral hazard by offering debtors the opportunity to avoid repaying on the loan’s original terms. If possible, design should mitigate such moral hazard and lead to a separating equilibrium in which only borrowers who are unable to repay their debt take advantage of the program. Depending on the financial situation of households, conditions can be attached to participation in the program. Conditions can include penalties that would present a disincentive for borrower defaults on restructured loans. For instance, borrowers may be required to allow banks to deduct direct loan repayments from their paychecks and incur the penalty of the original loan terms being restored if they default on the restructured terms. Alternatively, participation could require up-front cash payments, although such penalties may not be an option if households are already cash strapped. Beneficiaries could also be reported to the central credit register (if one exists) as restructured borrowers, limiting the scope for new loans. Above all, the borrowers’ capacity to repay has to be a key element of design.

A government-sponsored debt-restructuring program may include a combination of the following additional elements:

Incentives for borrowers. In general, borrowers will recognize the benefit of restructuring. Government incentives may on occasion be warranted to overcome obstacles to borrowers seeking restructuring; for example, it may be individually efficient for borrowers with significant negative equity to walk away from their mortgages, but costly to the economy as a whole. In such cases, the government might give incentives to borrowers to restructure loans on a voluntary basis through loan subsidies on restructured debt (such as subsidized interest rates for borrowers,10 subsidized refinancing, guarantees of payments,11 subsidized write-offs, and insurance against future exchange rate or interest rate changes). For distressed mortgages, the government might also subsidize conversion of part of the debt into a more equity-like instrument, such as a shared-appreciation mortgage, so that repayment depends on the value of the house when sold (possibly accompanied by the government sharing in the upside).

Incentives for lenders. Government incentives may include tax credits for restructured loans, low interest rate credit lines to banks, or the tying of the restructuring to a government-sponsored bank recapitalization program.12 Although the government may consider giving banks incentives to restructure loans by temporarily easing provisioning requirements on restructured loans, or by imposing unusually stringent provisioning on nonrestructured debt, such measures are to be avoided. Experience suggests that formal forbearance may work only in the framework of a comprehensive and credible bank-restructuring program that requires capital injections from bank shareholders. Nonetheless, in view of the potential for moral hazard and conflicts of interest, regulatory forbearance is risky even in the context of a bank-restructuring program. Thus, banking authorities should use this resource very cautiously and only in exceptional circumstances.13

Legal and institutional reforms. The utility of a debt-restructuring program is increased if backed up by an effective legal, institutional, and regulatory framework for the enforcement of creditor rights. In particular, an effective personal bankruptcy framework for addressing collective enforcement of creditor claims and rehabilitation of debtors may also be useful if multiple creditors are present. Although use of credit enforcement tools on a case-by-case basis would not be feasible for resolving large-scale defaults on household debt that may arise in a systemic crisis, the credible threat of their use as a last resort is important for setting markers for the behavior of debtors and creditors.

Specific measures to address loans denominated in foreign currency. When distressed household debt is largely denominated in foreign currency, consideration could be given to converting the debt into local currency. However, such conversion gives rise to a number of problems. In principle, local-currency conversion eliminates borrowers’ exposure to exchange rate flexibility, though its effects on the banking system will be country specific and depend on the net open currency positions of financial institutions. That said, conversion is likely to be prohibitively expensive for the banks and their borrowers, especially in systems with high levels of foreign-currency-denominated loans, unless the costs of conversion are transferred to the government.14 In addition, local-currency conversion may have adverse side effects on foreign exchange markets as lenders demand foreign currency to rebalance their portfolios. Then, for conversion to be an option, the foreign currency mismatch at financial institutions needs to be solved first, which requires the availability of foreign-currency-denominated liquid assets. Public support could be granted to banks in the form of dollar-denominated or indexed restructuring bonds to reduce the currency mismatch that arises on banks’ balance sheets after loans are converted into local currency, though the feasibility of such bonds depends on country circumstances, including the degree of dollarization of the economy.15 In particular, such bonds may not be sufficiently liquid to resolve funding problems at banks. In any case, forced conversion—for example, through legislative fiat—should be avoided.16 Forced conversion would give rise to legal challenges, may lead to a run on the currency as banks try to rebalance their portfolios, and would undermine the overall creditworthiness of a country.

Administrative measures as last resort. If the size of the debt problem is overwhelming and other tools, including government financial support, are ineffective, administrative measures may be used as a last resort. Administrative measures include the imposition of a standard way of modifying distressed loans (possibly differentiated according to local market conditions) and a payment moratorium or foreclosure ban on distressed loans. A debt-payment moratorium is particularly problematic because it interferes with contracts, negatively affecting the market’s perception of the quality of future contract enforcement, and would not address underlying debt overhang problems. Similarly, the imposition of an administrative ban on foreclosures does not solve the underlying debt overhang problems and could generate incentives to default by reducing the associated penalty, thereby exacerbating spillover effects on bank balance sheets. Other administrative measures, such as deposit freezes or the imposition of capital controls, should be avoided when possible, given the high economic costs they impose on future financial intermediation.

Other Policy Responses

Government-sponsored debt-restructuring programs are only one mechanism for restructuring household debt. The key advantage of these programs is simplicity and speed—recognizing loan losses up front thus providing immediate relief to borrowers. At the same time, debt restructuring does not directly impose losses on borrowers, thereby posing incentive problems, including moral hazard. However, these issues can be mitigated to some degree by targeting a select group of borrowers and through burden sharing with borrowers.

Household debt restructuring may also be facilitated indirectly through mechanisms supporting the financial health of banks such as recapitalizations and government purchases of distressed loans,17 for example, by transferring distressed loans to asset management companies (AMCs) better equipped to resolve these loans. A positive feature of recapitalization is that—depending on its political support—bank-specific public support can be provided more selectively, and can be based on the strength of the financial institution, taking into account prospective losses resulting from the resolution of distressed assets. The transfer of distressed loans to an AMC may facilitate household debt restructuring (while providing incentives to banks to recognize losses). However, such transfers are not without problems, including the risk of transferring assets at above-market prices, thus bailing out existing bank shareholders; offering support beyond that necessary to restore the debt viability of borrowers; and political and legal challenges in asset resolution. The experience with AMCs has been mixed, and their success depends largely on the legal and institutional environment.18

Countries typically apply a combination of these resolution strategies—with some directed toward financial institutions and others more geared toward borrowers—and in the process often incur substantial fiscal costs.19 The mix of policy responses will ultimately be crisis specific and depend on a variety of factors, including the nature and depth of the financial crisis, and specific country circumstances.

Appendix 17A. Brief Summaries of Previous Episodes of Household Debt Restructuring20

United States (1933)

In 1933, at the onset of the U.S. Great Depression, the Home Owners Loan Corporation (HOLC) was established to prevent mortgage foreclosures. HOLC bought distressed mortgages from banks in exchange for bonds with federal guarantees on interest and principal. It then restructured these mortgages to make them more affordable to borrowers and developed methods of working with borrowers who became delinquent or unemployed, including assisting them with job searches. Eligible mortgages included those with an appraised value of $20,000 or less ($321,791 in 2008 dollars). Approximately 40 percent of those eligible for the program applied; half of the applications were rejected or withdrawn. Of the 1 million loans HOLC issued, 200,000 homes were acquired from borrowers who were unable to pay their mortgages. HOLC ended up making a relatively small profit when it was liquidated in 1951, in part because declining interest rates and the government guarantee allowed it to borrow inexpensively.

Mexico (1998)

Following the unsuccessful FOBAPROA bank-restructuring program initiated in 1995, the government of Mexico initiated the Punto Final program in December 1998. The program was a government-led debt-relief program targeted at mortgage holders, agribusiness, and small and medium enterprises. The program offered large subsidies (up to 60 percent of book value of the loan) to bank debtors to pay back their loans. The discounts depended on the sector, the amount of the loan, and whether the bank restarted lending to the sector. For every three pesos of new loans extended by the bank, the government would assume an additional one peso of discount. The program thus combined loss sharing between the government and the banks with an incentive to restart lending. The program was successful in providing rapid debt relief but at very large cost to taxpayers.

Uruguay (2000)

In Uruguay, a debt-restructuring scheme approved in June 2000 offered a framework for the systemic and compulsory restructuring of small loans (up to US$50,000) by extending loan maturities and introducing gradually increasing payment schedules, and a largely voluntary scheme for large borrower workouts, with strong incentives for both banks and borrowers to reach restructuring agreements. Incentives to encourage creditor participation included (1) a flexible classification system for restructured loans to encourage banks to recognize implicit losses and (2) a reclassification as a loss with a 100 percent provisioning requirement for the failure to restructure a nonperforming loan within the timeframe provided by the scheme.

Republic of Korea (2002)

A rapid expansion of the credit card market in Korea, encouraged by lax lending standards and other factors, resulted in a distressed credit card market with rising delinquencies in 2002 (Kang and Ma, 2007). Credit card debt as percentage of GDP reached 15 percent in 2002. The credit card crisis spilled over to commercial banks because the banks were heavily exposed to troubled credit card issuers through credit lines. Korean commercial banks’ lending to one single large troubled credit card issuer stood at 38 percent of creditor banks’ combined equity. Nevertheless, Korea’s commercial banks were generally able to absorb the losses for their credit card units without broader repercussions because affected units were generally merged into the respective parent banks. The stand-alone credit card companies were more severely affected by the crisis. The principal way of dealing with the bad credit card debt was to write off the loans. Other resolution methods included sales to third parties and debt-to-equity conversions of credit card issuers’ debt. In addition, Korean authorities allowed issuers to roll over delinquent credit card loans, a practice known as “re-aging.” This form of regulatory forbearance eased the burden of provisions and charge-offs of these loans for issuers.

Argentina (2002)

The 2002 Argentine asymmetric pesification is an example of what not to do. In response to the crisis, in January 2002 Argentina introduced a heterodox economic program that included an external debt moratorium, an end to convertibility, and the introduction of a dual exchange regime. In February, the exchange regime was unified, the maturities of time deposits extended (the corralón), and bank balance sheets de-dollarized at asymmetric rates—Arg$1 per U.S. dollar on the asset side, and Arg$1.4 per U.S. dollar on the liability side. The assets and liabilities of the banks were also subjected to asymmetric indexation: deposits were indexed to the rate of consumer price inflation whereas certain loans were indexed to wage inflation.

This policy framework imposed significant losses on banks and depositors. The fiscal cost amounted to about 15 percent of GDP, largely due to fiscal outlays accruing to the banks;21 the losses suffered by banks far exceeded the entire net worth of the banking system. The deposit freeze and conversion resulted in a loss of depositor confidence and the collapse of financial intermediation. The conversion of deposits meant a dollar value erosion of 40 percent. Banks also lost because many of the creditworthy borrowers worrying about a further change in the government’s decision opted to pay off their loans. This left the banks with a smaller, lower-quality loan book. Most banks reported significant reductions in both staff and branches and remained cautious in expanding credit. The conversion led to a severe undercapitalization of the banking system. Moreover, depositors took advantage of exceptions and loopholes in the system, using judicial rulings to release frozen deposits at the market exchange rate. In this environment, a large number of banks were weakened and became dependent on the central bank liquidity window, accounting for 13 percent of total assets in 2003. The crisis had profound effects on the portfolio of the banking system. Private sector credit fell sharply, reflecting the collapse in credit demand and the repayments by existing borrowers. By 2003, loans to the private sector declined to 15 percent of total assets (US$8.4 billion) and exposure to the public sector increased to 50 percent of total assets.

Taiwan Province of China (2005)

Rapid expansion of credit card debt resulted in a distressed credit card market, although credit card losses mostly affected small and specialized institutions. The ratio of nonperforming loans (NPLs) to total loans for cash cards peaked at about 8 percent in 2006 (up from about 2 percent a year earlier), and for credit cards at about 3.5 percent (up from about 3 percent a year earlier). The system-wide NPL ratio was not visibly affected and continued the downward trend that started when Taiwan POC’s financial sector reform program began in 2000. Although the system-wide NPL ratio was not severely affected by the nonperforming card loans, there was a negative impact on the profitability of domestic banks. The average return on equity of domestic banks dropped to −0.41 percent at end-2006 (from 4.58 percent at end-2005), and the average return on assets dropped to −0.03 percent at end-2006 (from 0.31 percent at end-2005). To facilitate renegotiation of debt between credit card issuers and debtors, the authorities initiated a personal-debt-restructuring program offering better repayment terms, covering 30 percent of outstanding credit card balances. Restructured loans were largely reclassified as performing, effectively granting issuers regulatory forbearance.

United States (2008)

A prolonged credit boom, supported by low interest rates and lax underwriting standards, and the expectation of rising house prices, came to a halt in 2007. The bursting of the U.S. housing bubble led to rising foreclosures, which further depressed house prices. Foreclosures were increasing because of household debt overhang,22 coordination failures in arranging preforeclosure workouts, and legal impediments to loan workouts.23 The U.S. federal government introduced or sponsored a number of homeowner rescue programs, starting with the FHA-Secure program24 announced in August 2007, and the Hope for Homeowners (H4H) program,25 which was activated on October 1, 2008. These efforts met with very limited success in stemming foreclosures (for further details, see Kiff and Klyuev, 2009).

In addition, the Federal Deposit Insurance Corporation (FDIC) introduced a streamlined modification program for the mortgage loans it picked up from failed mortgage lender-servicer IndyMac.26 A similar program for Fannie Mae– and Freddie Mac–guaranteed mortgages was also introduced by the Federal Housing Finance Agency.27 They both use a stepwise decision process focusing on affordability, not negative equity.

Several large U.S. banks designed voluntary workouts of distressed mortgages. For example, Citigroup announced in early November 2008 that it would modify terms on mortgages for borrowers with debt-to-income ratios in excess of 40 percent. Modifications included a lowering of the interest rate, an extension of the terms of the loans, and as a last resort, a reduction in principal.

Also, some states imposed foreclosure moratoriums, typically three to six months long, but these were just temporary palliatives unlikely to be effective in the long run in the absence of a more comprehensive approach.

Hungary (2008)

In November 2008, Hungarian commercial banks—faced with increased credit risk in their loan portfolios denominated in foreign currency due to a sharp depreciation of the local currency—signed a gentleman’s agreement with the Ministry of Finance on a foreign-currency loan workout program.28

The workout provided borrowers with the following options: The first option was to apply to have their foreign-currency loans converted to forint-denominated loans. If they did so before the end of the year, they would not be charged additional fees. The second option was to ask for an extension of the loan duration free of charge if there was a significant increase in their monthly repayments. The third option was to ask for a temporary easing of repayment obligations, especially for borrowers who became unemployed. The key elements of the restructuring (the rate of loan conversion into the local currency and interest rates charged on restructured loans) were left to be determined by the parties involved. The conversion part of the program was not taken up because of high domestic interest rates.

In addition, the government was preparing legislation that would allow for temporary government guarantees (up to two years) on mortgage payments for those who became unemployed. Guarantees were available for mortgages outstanding up to 20 million Hungarian forint on primary residences only, and required that a minimum payment of 10,000 forint a month be maintained by the borrower.

United Kingdom (2008)

In early December 2008, the U.K. Treasury announced the Homeowners Support Mortgage Scheme to reduce the number of home foreclosures. Under the scheme, U.K. homeowners struggling to make mortgage payments could defer a portion of their payments by up to two years. Borrowers with mortgages up to £400,000 and with savings lower than £16,000 were eligible to roll up mortgage payments into the principal, and pay off the principal when conditions improved. The U.K. Treasury was to guarantee the deferred interest payments for those banks participating in the scheme. Most of the country’s largest lenders agreed to participate in the program.

Table 17A.1 summarizes household indicators for each of the case studies, except for the recent episodes in Hungary, the United Kingdom, and the United States.

Table 17A.1Household Indicators before and after Debt Restructuring
United States (1933)Mexico (1998)Uruguay (2000)Korea, Rep. of (2002)Argentina (2002)Taiwan Province of China (2005)
193219361997200119992003200120052001200520042008
Household income growth (%)–25.815.15.2–1.2–3.32.33.13.7–5.48.1
Consumption growth (%)–21.59.76.52.5–1.52.04.93.6–5.78.94.51.3
Unemployment rate (%)22.714.23.72.811.315.44.03.720.710.14.43.9
Private debt/GDP (%)45.432.124.514.549.846.492.7100.320.811.7
Source: IMF staff estimates.
Source: IMF staff estimates.
References

Debt overhang is a situation in which a borrower’s debt exceeds his or her future capacity to repay. The debt overhang problem has been analyzed for firms by Myers (1977). Krugman (1988), among others, provides an analysis for sovereign debt.

The analysis does not address the weakening supply of credit or temporary liquidity problems of households, nor does it address efforts to support asset prices or banking sector resolution. The chapter also does not deal with complexities associated with the link between household debt and structured credit products (for example, through securitization) as in some advanced economies. A complete analysis that would address these other problems could alter the design of the debt-restructuring strategy and call for additional policy measures not covered by the chapter.

Table 17.1 indicates the legal costs and time associated with typical corporate (not individual) bankruptcy proceedings in selected economies, highlighting the variation in such costs across countries. These data are compiled in normal times. The noted delays would be expected to be significantly longer in the context of wide-scale corporate insolvencies associated with systemic crises. No similar data on personal insolvency proceedings is available.

Since the burst of the U.S. housing bubble in 2007, the U.S. federal government has introduced or sponsored several initiatives to prevent rising foreclosures, including the FHA-Secure program announced in August 2007 and the Hope for Homeowners (H4H) program started on October 1, 2008. These efforts met with very limited success in stemming foreclosures, largely because they targeted severely delinquent borrowers who without more generous support were not able to service their mortgage payments. In March 2009, the U.S. Treasury introduced a more comprehensive initiative aimed at mitigating mortgage foreclosures, the Homeowners Affordability and Stability Plan. The program establishes guidelines for affordable loan modifications and refinancing aimed at reducing monthly payments to sustainable levels and provided incentives for loan modifications for borrowers, lenders, and other participants of the mortgage market, including through the personal bankruptcy mechanism as the last resort. It also contained other measures to support the housing market, including through increased funding commitments to the government-sponsored agencies, renter assistance, grants for innovative local programs to reduce foreclosures, and counseling for the most heavily indebted borrowers.

In addition, debt-counseling services can be an effective tool for encouraging individuals to address their debt problems at an early stage by providing them with professional advice on their legal rights and responsibilities and on applicable procedures for negotiation. The insolvency law can facilitate the use of these services by making their use a condition to debtors filing for rehabilitation in insolvency proceedings. For a general discussion of key principles of individual insolvency law, see INSOL International (2001).

Examples of government-sponsored debt-restructuring programs that targeted certain groups of loans are the 1933 Home Owners Loan Corporation program in the United States, the 1998 Punto Final program in Mexico, the 2000 debt-restructuring program in Uruguay, the 2002 credit card debt program in the Republic of Korea, and the 2008 IndyMac loan modification program in the United States. See Appendix 17A for a brief description of previous country episodes of household debt restructuring.

These basic features are designed on the model of a single main creditor for each household debtor and thus does not address creditor coordination and inter-creditor equity issues that would arise in countries in which multiple creditors of household debtors are prevalent.

However, banks’ participation may be enhanced by making it mandatory for banks that receive public funds, for example, in the context of a government-orchestrated bank-restructuring program.

Compulsory loan-restructuring programs have been rare. In the corporate debt context, Uruguay introduced a framework for compulsory restructuring of small loans in June 2000 to deal with large-scale debt overhang in the corporate sector. Under the program, loan maturities were extended under gradually increasing repayment schedules. Compulsory restructuring decreases the bargaining power of banks in the debt-restructuring process, which could be beneficial in circumstances in which banks have capacity to restructure but are recalcitrant. However, the risk of legal challenge and the potential to damage the credit culture likely outweigh the potential benefits of compulsory restructuring.

See the description in Appendix 17A of the Punto Final program adopted by Mexico in 1998.

See the description in Appendix 17A of the Homeowners Support Mortgage Scheme introduced by the U.K. Treasury in early December 2008.

Many countries allow their banks to upgrade restructured loans that were classified as loss or doubtful before restructuring into the substandard category after a new debt profile has been prepared on the basis of the borrower’s more realistic repayment capacity. After a certain number of payments on the basis of the new schedule have been made (international practice varies between 6 and 12 monthly payments), these restructured loans can often be upgraded further.

Although not best practice, some countries have eased provisioning requirements when faced with a surge in nonperforming loans. See Appendix 17A for instances in the Republic of Korea (2002) and Taiwan Province of China (2005).

In November 2008, Hungarian commercial banks, faced with increased credit risk in their loan portfolios denominated in foreign currency as the result of a sharp depreciation of the local currency, signed a gentleman’s agreement with the ministry of finance on a foreign-currency loan workout program that included the option to convert foreign currency loans into Hungarian-forint-denominated loans. The conversion part of the program was not taken up by borrowers because of the perceived cost of conversion implied by domestic interest rates that are much higher than interest rates on foreign currency loans.

Such foreign-currency-denominated restructuring bonds have been used before in Bulgaria (1994, 1997, 1999), Korea (1998), Mexico (1995–96), Poland (1991), and Uruguay (1982–84), while foreign-currency-indexed restructuring bonds have been used in Indonesia (1998–2000) and Nicaragua (2000–01). However, in all these countries, these bonds were issued as part of more general bank-restructuring programs rather than household debt-restructuring programs. See Hoelscher (2006) for further details.

The 2002 Argentine asymmetric pesification is an example of a forced debt-conversion program that imposed significant losses on banks and depositors, with profoundly negative implications for financial intermediation and future economic growth. See Appendix 17A.

An example of a government program that involved government purchases of distressed loans is the U.S. Home Owners Loan Corporation (HOLC) established in 1933. See Appendix 17A.

Although a detailed analysis of the pros and cons of using an AMC as a debt-restructuring tool is beyond the scope of this chapter, in addition to valuation of the assets to be transferred, other key issues that need to be addressed in setting up and operating an AMC include (1) whether the AMC is fully financed by the government or through a combination of government and other (e.g., official and private sector) financing; (2) risk- and loss-sharing arrangements if the AMC has more than one shareholder; and (3) the governance and decision-making structure of the AMC.

For a more extensive overview of how crisis resolution policies have been used in past financial crises and the trade-offs involved, see Hoelscher and Quintyn (2003), and Honohan and Laeven (2005).

Some of the cases described in this appendix touch on the issues that go beyond the intended coverage of the chapter. Table 17A.1 presents data on selected household indicators for each case study (except the recent cases of Hungary [2008], the United Kingdom [2008], and the United States [2008]).

A large fraction of this fiscal cost included subsidies to banks to compensate for the asymmetric pesification and asymmetric indexation.

About 10 million U.S. homeowners reportedly had negative equity, and more than half of subprime borrowers had debt-to-income ratios exceeding 38 percent, a level below which loans are generally deemed affordable in the United States.

Including no-recourse mortgages that allow “under water” borrowers to walk away from affordable loans; bankruptcy law that does not allow modification of unaffordable mortgages on principal residences; and lack of safe harbor for loan modifications that leaves servicers open to lawsuits from disgruntled investors.

FHA-Secure, introduced on August 31, 2007, and significantly amended on May 7, 2008, offered stressed homeowners an opportunity to refinance into FHA-insured loans. The lender had to agree to write the loan off (via a “short refinancing”) for an amount not to exceed 97 or 90 percent of the current appraised home value, depending on the borrower’s recent payment record. The 97 percent LTV applied to borrowers who had not missed more than two monthly payments (individually or consecutively) during the previous year, and 90 percent to borrowers who had missed up to three monthly payments. The payments on the new loan were not to exceed 31 percent of income, and the total of all debt payments (home and nonhome) were not to exceed 43 percent. Delinquent borrowers had to pay a 2.25 percent up-front mortgage insurance premium and 55 basis points annually, while current borrowers paid 1.50 and 0.50 percent. The program, however, was not successful in overcoming the difficulties identified in this chapter. The number of FHA-Secure refinancings was disappointing, and it was phased out at the end of 2008.

The H4H program improved on FHA-Secure by covering severely delinquent borrowers and providing incentives for second-lien write-offs. It applies to mortgages on primary residences originated before January 2, 2008, and to borrowers whose current mortgage payments exceed 31 percent of gross income. The lender has to agree to write the loan off for an amount not to exceed 96.5 percent of the current appraised value, and waive all prepayment penalties and late payment fees. This “short refinancing” is funded by a new 30- or 40-year, fixed-rate, FHA-insured loan with payments that are at or below 31 percent of income, and all debt payments (home and nonhome) must be at or below 43 percent. For borrowers with higher debt loads, the debt-to-income ratio can be expanded to 38 percent but, in this case, the new principal amount cannot exceed 90 percent of current appraised value. The first lien holder also pays a 3 percent up-front FHA insurance premium, and the homeowner pays a 1.50 percent annual premium. In addition, if the homeowner sells the house or refinances the new mortgage, the Department of Housing and Urban Development gets back some of the “instant” equity (100 percent in the first year, declining to 50 percent after five years), plus, if the property is sold, 50 percent of any net house price appreciation. Also, borrowers are prohibited from taking out new subordinated liens during the first five years, except when necessary to ensure maintenance of property standards.

Under the IndyMac loan-modification program, eligible mortgages were modified into sustainable mortgages at a permanently reduced interest rate to achieve sustainable payments at a 38 percent debt-to-income ratio. The loan modification was available for borrowers on a first mortgage on their primary residence owned or securitized and serviced by IndyMac if the borrower was seriously delinquent or in default. The loan modification did not involve fees or other charges for the borrower. The IndyMac scheme is an example of a voluntary loan workout scheme.

First, they only consider for modification loans that are seriously delinquent (60 days or more for the FDIC program and 90 days for the FHFA program), to borrowers who own and occupy the property and who have not filed for bankruptcy. The programs then attempt to find the modification with the minimum net present value impact that achieves a 38 percent debt-to-income ratio. The sequential process used by the FDIC program starts by capitalizing the arrearage into the unpaid balance, and if the resulting payment puts the borrower’s DTI above 38 percent, interest rate reductions and amortization term extensions are offered. If the DTI is still above 38 percent, principal forbearance is applied, involving converting a portion of the unpaid balance into a zero interest note due when the mortgage is paid off. Seriously delinquent loans, for which these modifications are insufficient to achieve the DTI targets, can still be considered on a case-by-case basis.

Reportedly, the agreement was signed somewhat reluctantly by the largest nine commercial banks, after the Ministry of Finance had stated it would introduce legislation to the same effect.

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