Back Matter

Appendix I Brief Summaries of Previous Episodes of Household Debt Restructuring21

A. 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 job searches. Eligible mortgages include mortgages with an appraised value of $20,000 or less ($321,791 in 2008 dollars). Approximately 40 percent of those eligible for the program applied and half of these applications were rejected or withdrawn. Of the one million loans HOLC issued, it acquired 200,000 homes 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.

B. Mexico (1998)

Following the unsuccessful FOBAPROA bank restructuring program initiated in 1995, the government of Mexico initiated in December 1998 the Punto Final program, which was a government-led debt relief program targeted at mortgage holders, agribusiness, and small and medium-sized enterprises. The program offered large subsidies (up to 60 percent of the 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 on 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 terms of rapid debt relief but at very large cost to the taxpayer.

C. 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 (i) a flexible classification system for restructured loans to encourage banks to recognize implicit losses; and (ii) a reclassification as a loss with a 100 percent provisioning requirement of the failure to restructure a nonperforming loan within the timeframe provided by the scheme.

D. 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 2002.22 Credit card debt as percentage of GDP reached 15 percent in 2002. The credit card crisis spilled over to commercial banks, as commercial 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, as affected credit card units were generally merged into the respective parent banks. The stand alone credit card companies were generally more severely impacted by the credit card crisis. The principal ways of dealing with the bad credit card debt were loan writeoffs. Other resolution methods employed include sales to third parties and debt-to-equity conversions of credit card issuers’ debt. In addition, Korean authorities allowed credit card issuers to roll over delinquent credit card loans, a practice known as “re-ageing.” This form of regulatory forbearance eased the burden of provisions and charge-offs of these loans for issuers.

E. Argentina (2002)

The 2002 Argentine asymmetric pesofication is an example of what not do to. Argentina introduced a heterodox economic program in response to the crisis in January 2002 that included an external debt moratorium, an end to Convertibility, and 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 dedollarized at asymmetric rates—Arg$1 per dollar on the asset side, and Arg$1.4 per 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 while 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 banks23; 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 in 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 government’s decision opted to pay off their loans. This left the banks with a smaller and a lower quality loan book. Most banks reported significant reductions in both staff and in 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 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, the loans to the private sector declined to 15 percent of total assets (US$8.4 billion) while exposure to the public sector increased to 50 percent of total assets.

F. 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 (NPL) 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 its downward trend that began when Taiwan POC’s financial sector reform program began in 2000. Whilst the system-wide NPL ratio was not that much affected by the nonperforming card loans, there was a negative impact on the profitability of domestic banks. Average return on equity of domestic banks dropped to –0.41 percent at end-2006 (from 4.58 percent at end-2005) and 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.

G. 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 burst of the U.S. housing bubble led to rising foreclosures, which further depressed house prices. Foreclosures are on the rise because of household debt overhang,24 coordination failures in arranging pre-foreclosure workouts, and legal impediments to loan workouts.25 The U.S. federal government has introduced or sponsored a number of homeowner “rescue” programs, starting with the FHASecure program26 announced in August 2007, and more recently the Hope for Homeowners (H4H) program,27 which was activated on October 1, 2008. These efforts have met with only very limited success in stemming foreclosures.28

In addition, the Federal Deposit Insurance Corporation (FDIC) has introduced a streamlined modification program for the mortgage loans it picked up from failed mortgage lender/servicer IndyMac.29 A similar program for Fannie Mae and Freddie Mac guaranteed mortgages was also introduced by the Federal Housing Finance Agency (FHFA).30 They both use a stepwise decision processes that focuses on affordability, and not negative equity.

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

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

H. Hungary (2008)

In November 2008, Hungarian commercial banks—faced with increased credit risk of 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.31

The workout provides the borrowers with the following options: (a) apply to have their foreign currency loans converted to forint-denominated loans. If they do so before the end of the year, they will not be charged additional fees; (b) ask for an extension of the loan duration free of charge if there is a significant rise in their monthly repayments; and (c) ask for a temporary easing of repayment obligations, especially for borrowers who become unemployed. The key elements of the restructuring (i.e. 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 has not been taken up because of high domestic interest rates. In addition, the government is preparing a legislation that would allow for temporary government guarantees (up to two years) on mortgage payments for those who become unemployed. While the final details are not available yet, preliminary reports suggest that the guarantees will be available for mortgages outstanding up to 20 million HUF, on primary residence only, and would require that a minimum payment of 10,000 HUF a month is maintained by the borrower.

I. United Kingdom (2008)

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 can defer a portion of their payments by up to 2 years. Borrowers with mortgages up to £400,000 and with savings lower than £16,000 are eligible to roll up mortgage payments into the principal, and pay off the principal when conditions improve. The U.K. Treasury will 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 2.

Household indicators, pre- and post-debt restructuring

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1

The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. The main authors of this paper are Luc Laeven (Research Department (RES)) and Thomas Laryea (Legal Department (LEG)), with inputs from Giovanni Dell’Ariccia (RES) and Nadia Rendak (LEG). The authors thank Jochen Andritzky, Tam Bayoumi, Olivier Blanchard, Stijn Claessens, Luis Cortavarria-Checkley, Karl Driessen, Sean Hagan, Antonio Ignacio Garcia Pascual, David Hoelscher, Yan Liu, Mauro Mecagni, James Morsink, Martin Muhleisen, Ceyla Pazarbasioglu, Catriona Purfield, Guillermo Tolosa, Fabian Valencia, Tessa van der Willigen, Johannes Wiegand, and members of the interdepartmental Debt Restructuring Working Group for helpful discussions and comments. See also the note on “Approaches to Corporate Debt Restructuring Relevant for Emerging Country Crises” prepared by this group. Contact information: llaeven@imf.org or tlaryea@imf.org

2

Debt overhang is a situation where a borrower’s debt exceeds his/her future capacity to repay. The debt overhang problem has been analyzed for firms by Myers. (S. Myers, 1977, “Determinants of Corporate Borrowing,” Journal of Financial Economics, Vol. 5, pp. 147–75.) and for sovereign debt by Krugman (P. Krugman, 1988, “Market-Based Debt-Reduction Schemes,” NBER Working Paper No. W2587 (Cambridge, Massachusetts)), among others.

3

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 note 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 note.

4

Table 1 indicates the legal costs and time associated with typical corporate (not individual) bankruptcy proceedings in selected economies, highlighting that there is much 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.

5

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 FHASecure program announced in August 2007 and the Hope for Homeowers (H4H) program started on October 1, 2008. These efforts have met with only very limited success in stemming foreclosures, largely because they target severely delinquent borrowers who without more generous support will not be able to service their mortgage payments. In March 2009, the U.S. Treasury introduced a more comprehensive initiative aimed at mitigating mortgage foreclosures, the Homeowner Affordability and Stability Plan. The program establishes guidelines for affordable loan modifications and refinancing aimed at reducing monthly payments to sustainable levels and provides 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 includes 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.

6

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

7

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 Korea, and the 2008 Indymac loan modification program in the United States. See Appendix I for a brief description of previous country episodes of household debt restructuring.

8

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 where multiple creditors of household debtors are prevalent.

9

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

10

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 where banks, have capacity to restructure but are recalcitrant. However, the risk of legal challenge and the potential to deteriorate the credit culture likely outweigh potential benefits of compulsory restructuring.

11

The Punto Final program adopted by Mexico in 1998 is an example of a debt relief program that involved government subsidies to bank creditors. The program targeted mortgage holders, agribusiness, and small and medium-sized enterprises and offered large government subsidies in the form of loan discounts. The program offered rapid debt relief but at a very large cost to the taxpayer.

12

The Homeowners Support Mortgage Scheme introduced by the U.K. Treasury in early December 2008 to reduce the number of home foreclosures offers homeowners struggling to make mortgage payments an option to defer mortgage payments and includes a government guarantee on deferred interest payments for those banks participating in the scheme.

13

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

14

While not best-practice, some countries have eased provisioning requirements when faced with a surge in nonperforming loans. For example, when faced with rising delinquencies on credit cards in 2002, Korean authorities allowed credit card issuers to roll over delinquent credit card loans, a practice known as “re-aging,” to ease the burden of provisions and charge-offs of these loans for issuers. Similarly, authorities in Taiwan POC when faced with a distressed credit card market in 2005, allowed restructured loans to be reclassified as performing, effectively granting credit card issuers regulatory forbearance.

15

In November 2008, Hungarian commercial banks – faced with increased credit risk of 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 that includes the option to convert foreign currency loans into forint-denominated loans. The conversion part of the program has thus far not been 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.

16

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 have been issued as part of more general bank restructuring programs rather than household debt restructuring programs. See David Hoelscher, 2006, Bank Restructuring and Resolution (Washington: International Monetary Fund), for further details.

17

The 2002 Argentine asymmetric pesofication is an example of a forced debt conversion program that imposed significant losses on banks and depositors, with profound negatively implications for financial intermediation and economic growth going forward. The program started with an external debt moratorium, an end to convertibility of the local currency, and the introduction of a dual exchange regime. A month later, the exchange regime was unified, and bank balance sheets were dedollarized at asymmetric rates and indexation, imposing large losses on both banks and depositors.

18

An example of a government program that involved government purchases of distressed loans is the U.S. Home Owners Loan Corporation (HOLC) established to in 1933. 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 job searches.

19

While a detailed analysis of pros and cons of using an AMC as a debt restructuring tool goes beyond the scope of this note, 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: (i) whether the AMC is fully financed by the government or through a combination of government and other (e.g., official and private sector) financing; (ii) risk/loss sharing arrangements if the AMC has more than one shareholder; and (iii) governance/decision making structure of the AMC.

20

For a more extensive overview of how crises resolution policies have been used in past financial crises and the tradeoffs involved, see David Hoelscher and Marc Quintyn, 2003, Managing Systemic Financial Crises, IMF Occasional Paper No. 224 (Washington: International Monetary Fund); and Patrick Honohan and Luc Laeven, 2005, Systemic Financial Crises: Containment and Resolution (Cambridge: Cambridge University Press).

21

Some of the cases described in this Appendix touch on the issues that go beyond the intended coverage of the note as outlined in Section I. Table 2 presents data on selected household indicators for each case study (except the ongoing cases).

23

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

24

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

25

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.

26

FHASecure, introduced on August 31, 2007 but 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 non-home) were not to exceed 43 percent. Delinquent borrowers had to pay a 2.25 percent up-front mortgage insurance premium (UFMIP) and 55 basis points annually, while current borrowers paid 1.50 and 0.50 percent. The program, however, has not been successful in overcoming the difficulties identified in the previous section. The number of FHASecure refinancings has been disappointing, and it was phased out at the end of 2008.

27

The H4H program improves on FHASecure by covering severely delinquent borrowers, and providing incentives for 2nd 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 ensuring that all debt payments (home and non- home) are 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 1st lien holder also pays a three percent upfront 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 (HUD) 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 HPA. Also, borrowers are prohibited from taking out new subordinated liens during the first five years, except when necessary to ensure maintenance of property standards.

28

For further details, see J. Kiff and V. Klyuev, 2009, “Foreclosure Mitigation Efforts in the United States: Approaches and Challenges,” forthcoming IMF Working Paper (Washington: International Monetary Fund).

29

Under the IndyMac Loan Modification Program, eligible mortgages will be modified into sustainable mortgages at a permanently reduced interest rate to achieve sustainable payments at a 38 percent debt-to-income ratio. Eligibility for the loan modification will be available for borrowers on a first mortgage on their primary residence which is owned or securitized and services by IndyMac where the borrower is seriously delinquent or in default. The loan modification does not involve fees or other charges for the borrower. The IndyMac scheme is an example of a voluntary loan workout scheme.

30

Firstly, 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 NPV impact that achieves a 38 percent DTI. 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 over 38 percent, interest rate reductions and amortization term extensions are offered. If the DTI is still over 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.

31

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.