Pages

September 29, 2008

Is the current US / World situation more like Mexico's crisis of 1994-1998 ?

People have mostly been comparing the current crisis to the Japanese financial crisis and decade of economic stagnation. However there have been other foreign financial crisis that may be a closer parallel. All of the foreign financial crisis provide examples of what should be avoided. A series of direct support programs in Mexico to homeowners failed because it created a culture of non-payment for mortgages. Home prices have to get stabilized and programs have to be designed to keep people in their homes and making what payments that they can. Japan showed the failure of acting too slowly with programs that were too weak.

Mexican taxpayers have been asked to absorb the cost of bailing out the country's banks after the 1994 peso collapse and, in addition, bear the burden of any new bad loans the institutions have amassed since then [1994-1998].


Here is a 2000 Harvard paper that examines the crisis faced by Mexico and the failed attempts to Mexican attempt bailout its banks and homeowners.

The currency devaluation that Mexico suffered at the end of 1994 set off a recession and banking crisis from which the country has still not fully recovered. The housing market has been one of the sectors most seriously affected. Despite attempts by the government to aid banks and borrowers with mortgage loans, default rates have remained high.

The results of this study provide insight into why the ADE government aid program
failed between 1995 and 1996. Loan contracts that permitted excessive negative amortization coupled with a decline in property values left many borrowers with negative equity in their homes. With negative home equity, borrowers default to maximize wealth. Nearly two decades of research on mortgage pricing have shown that default should be viewed as a contingent claim attached to the mortgage contract. Lenders sell a put option when they originate a mortgage that explicitly allows the borrower to relinquish the home at the price of the mortgage. When the value of the outstanding loan exceeds the value of the house, the put is in the money and a rational, wealth-maximizing borrower will default. Mexican mortgage holders have largely responded, as financial theory would predict, by exercising the put option to default on their loans.

Direct discounts off the balance of the loan would have been a more effective policy for stemming default and encouraging restructure. Eventually, nearly three years later, the government did decide to support banks in granting such discounts through a program called Punto Final. By this time, however, borrowers had grown to expect a new relief program each time delinquency rose. Strategic default was well cultivated in the market making it ever harder to attain positive results even from a well-designed program. Successive policy failures, such as that of the ADE program, helped nurture a culture of non-payment.








FURTHER READING
Another academic paper examining Mexico's problems up to 1994

Japan's handling of its financial crisis also shows what does not work well.
blog comments powered by Disqus