The lack of debt relief to the distressed households is the reason why this financial crisis is becoming more severe and the economic recession – with a sharp fall now in real consumption spending – now worsening. The fiscal actions taken so far (income relief to households via tax rebates) and bailouts of distressed financial institutions (Bear Stearns creditors’ bailout, Fannie and Freddie and AIG) do not resolve the fundamental debt problem for two reasons. First, you cannot grow yourself out of a debt problem: when debt to disposable income is too high increasing the denominator with tax rebates is ineffective and only temporary; i.e. you need to reduce the nominator (the debt). Second, rescuing distressed institutions without reducing the debt problem of the borrowers does not resolve the fundamental insolvency of the debtor that limits its ability to consume and spend and thus drags the economy into a more severe economic contraction.
So of the five possible uses of fiscal policy – income relief to households (the 2008 tax rebate), rescue/bailout of financial institutions (Bears Stearns, Fannie and Freddie, AIG), purchase of assets of failed institutions (an RTC-like institution), recapitalization of undercapitalized financial institutions (an RFC-like institution), government purchase of distressed mortgages to provide debt relief to households (an HOLC-like institution) – the last option is the most important and effective to resolve this severe financial and economic crisis. During the Great Depression the Home Owners’ Loan Corporation was create[d] to buy mortgages from bank at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed rate mortgage rates. This massive program allowed millions of households to avoid losing their homes and ending up in foreclosure. The HOLC bought mortgages for two year and managed such assets for 18 year at a relatively low fiscal cost (as the assets were bought at a discount and reducing the face value of the mortgages allowed home owners to avoid defaulting on the refinanced mortgages). A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced; thus it will be the macro equivalent of the “bad bank” that Lehman tried to create for its bad assets.