The lesson lenders learned from the Great Recession: Forbearance works

Lenders and the federal government apparently learned a lesson from the financial crisis of 2008–09. As a result, the financial pain of the pandemic has been much gentler than it otherwise might have been. So says a just-released paper from researchers at the business schools of Columbia University, Northwestern University, Stanford University, and the University of Southern California.

The evidence shows up in seemingly bizarre statistics gauging household debt during the pandemic. When COVID-19 arrived last March and unemployment spiked, delinquency rates on consumer loans plunged—the opposite of what happened in the financial crisis and in virtually all other downturns. For example, in the financial crisis, mortgage delinquencies jumped from 2% to 8%, but in the pandemic’s first seven months they fell from 3% to 1.8%. “This is especially striking,” the researchers note, “given an unprecedented increase in the unemployment rate that reached almost 15% in [the second quarter of 2020] and the strong historical association between the unemployment rate and mortgage default.”

The explanation isn’t just stimulus checks. Even more important is the way government and private lenders responded to lockdowns and mass unemployment. Instead of cracking down on delinquent borrowers—foreclosing on homes, repossessing autos, declaring other debts in default—they offered forbearance far more generously than ever before. Forbearance doesn’t reduce a borrower’s debt. It just permits the borrower to put off some payments until later without the lender declaring the borrower delinquent and denting the borrower’s credit rating.

Going easy on debtors turns out to be a wise move from two perspectives: what’s good for the overall economy and what’s good for individual companies and borrowers. In the big picture, overburdened households undermine the whole economy—what economists call “the standard household debt distress channel.” During the financial crisis, the spike in mortgage delinquencies sent home prices into a self-reinforcing downward spiral as homeowners rushed to sell and banks put foreclosed properties on the market, forcing prices down and prompting other homeowners to sell before prices went even lower. Overall demand collapsed, pushing the economy into a hole that took three years to escape.

That’s why the CARES Act included a section requiring forbearance of federally insured mortgages—the vast majority of all mortgages. “Most potential delinquencies in the mortgage market were averted because of forbearance,” the researchers believe, and it appears that “the low delinquencies explain at least in part why the pandemic has not resulted in house price declines.”

Yet the broad surge in forbearance wasn’t solely a result of government action. Lenders unaffected by the CARES Act decided for their own reasons that forbearance was the smart way to go. Delinquency rates on auto loans and credit card debt plunged, and forbearance increased, without any government mandate. Lenders realized that it costs money to repossess cars and chase down cardholders who can’t make their payments; economists call those costs “deadweight losses.” It’s often better in the end to give borrowers more time.

Why such a stark difference between the responses to this downturn and the last one? The researchers conclude that “the private sector and policymakers may have internalized the lessons from the Great Recession pointing to significant costs of widespread defaults and foreclosures and were more willing to provide debt relief.” It’s also possible, they say, that “the underlying adverse shock has been perceived as more transitory relative to the prior crisis.”

The new research’s bottom line is that “massive consumer debt forbearance actions can help explain why, unlike during the Great Recession, the standard household debt channel was largely absent during the first year of the COVID-19 pandemic.” That’s good news. Even better is that this lesson is the one policymakers will carry with them into the next downturn.

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