How should the government support households with unpayable debts?

In the now seemingly likely event of a slow recovery from the Covid-19 recession and high levels of unemployment, the government will need schemes to manage insolvency for households at risk of being unable to pay their debts. What types of support will be most effective?

UK government intervention to support households during the Covid-19 crisis to date is predicated on a V-shaped economic recovery in which household incomes bounce back quickly. Current evidence, including the fiscal projections issued in July by the Office for Budget Responsibility (OBR), suggests that the process of recovery will be much slower, with elevated levels of unemployment expected to persist for some time under even an ‘optimistic’ scenario for the economy (OBR, 2020).

This suggests that a new policy mix is required. The government may need to introduce schemes to manage insolvency or restructure debt payments for households with unpayable debts. This article explores the possible options and evidence from existing research on their effectiveness.

Will current policy be enough?

Following the introduction of lockdown, the government, the central bank and regulators moved quickly to introduce two unprecedented policies that form the main support for household finances:

First, the Coronavirus Job Retention Scheme, or ‘furlough’ scheme, to support household incomes.
Second, payment ‘holiday’ schemes for mortgages and consumer credit payments, under which individuals defer their payments, currently for up to six months (during which interest continues to accrue on loans).

Additional measures have provided households with considerable extra support including increased benefits, support schemes to help those who are self-employed, provision of payment holidays on other debts and the decision to prevent repossessions or rental evictions occurring until after the summer of 2020.

Related question: Why should the government provide income protection in a recession?

The effectiveness of all of these policies is predicated on the assumption that incomes and jobs will bounce back – what some call a V-shaped economic recovery – in which case the aim is simply to provide households with cash in the short term. But much emerging evidence suggests that this outcome for the economy is unlikely.

First, the recovery of consumer spending currently seen in the UK is significant, but still some way below pre-coronavirus levels (the same is true in Germany), suggesting that growth will not shoot back as consumers remain cautious.

Second, the structural change induced by the online revolution accelerated by coronavirus may result in an economic recovery that is lighter on jobs, as a significant share of face-to-face retail (in particular) and some services experience permanent structural decline.

A sizeable increase in unemployment, and associated reductions in household incomes and increases in difficulties in paying debts, now seem inevitable, at least is the short term.

This presents the question of how should policy evolve to support households that suffer persistent unemployment and are therefore faced with unpayable debts?

Who will need support?

An important observation is that the crisis is not affecting all households equally, with certain types of households most at risk of unpayable debts (Costa Dias et al, 2020). The households being hit hardest by the crisis are those towards the bottom of the income distribution, particularly those whose members are employed in sectors more exposed to the social distancing and structurally transformative implications of the crisis, such as retail, hospitality and face-to-face services.

These households are more likely to struggle with unpayable debts on consumer credit, utilities and council tax, but they are less likely to fall into mortgage arrears, because they are less likely to own their own homes (Bourquin, 2020).

Low-income households are also characterised by poorer financial literacy, suggesting that there might be a particular need for increased credit counselling and support targeted to these households (Gathergood and Wylie, 2018).

Related question: What will be the impact of the crisis on household finances?

What types of support are available?

There are two broad policy options for households facing unpayable debts:

First, offer short-term liquidity – that is, cash in hand - in anticipation of household incomes recovering (the current policy).
Second, offer means by which insolvent households can discharge their debts, such as bankruptcy.

There is also a third option, which is to move to income-contingent repayments. This type of loan is only repayable when an individual's income receipts go above a certain level, and can include a date by which the debt is automatically discharged if the loan is not repaid. Income-contingent student loan repayments are an example of this type of scheme.

While an income-contingent repayment scheme has attractive features – avoiding both liquidity crises and insolvency crises – it also has some substantial drawbacks. Most importantly, the scheme increases effective marginal tax rates: individuals face an increasing tax on their earnings as they earn more. This means that it is likely to discourage some people from working more, thereby reducing output as well as reducing debt repayments (Britton and Gruber, 2019).

The scheme also results in unpredictable cashflows for lenders and uncertain liabilities for the government.

What are the options in the housing market?

In the housing market, if the scale of unpayable debts among homeowners does increase, policy may need to move away from short-term payment holidays (liquidity management) to a version of orderly debt restructuring (insolvency management). This is necessary because the disruption caused by mortgage repossessions, evictions and sales creates losses for households, banks and government. Households lose their homes, with significant negative effects of destabilisation, particularly for children.

Related question: How might the crisis affect children from poorer backgrounds?

Repossessions are costly for banks. Repossessed properties sell at lower values, present security risks and pose a challenge to banks of managing a property portfolio – banks on average make a net loss of £40,000 per property repossessed.

The disorderly disruption of the UK housing market in the recession of the early 1990s saw a ‘fire sale’ of repossessed housing, greatly depressing prices and thereby generating the spillover problem of ‘underwater’ mortgages for households seeking to remortgage (the problem of ‘negative equity’, where the value of a house is below the mortgage outstanding on it).

Mortgages are long-dated secured loans, currently at historically low interest rates, so there is limited scope to restructure them through extended maturity or subsidised interest rates, although there is evidence that restructuring is effective in reducing repossessions (Ganong and Noel, 2020).

One feasible policy would be for the government to support mortgage payments directly in return for taking a secured second charge on the property, that is, an equity position (as is currently done under the Help to Buy Scheme for new purchasers). This would be limited such that the value of the government mortgage and bank mortgage together sum below a set loan-to-value threshold (for example, 95%).

The long-term performance of the housing market and labour market indicates that the government is unlikely to incur significant losses from such a programme as households regain employment and house prices increase in the medium-term.

Related question: After coronavirus, can the housing market support economic recovery?

What are the options for unsecured debts?

Broader problems of unpayable and escalating debts are more likely to materialise in the consumer credit market. We may see very widespread delinquencies on credit cards, personal loans and other forms of credit.

Here, there is scope for much-needed reform of the personal insolvency regime in the UK. The current regime, built on bankruptcy and individual voluntary arrangements, is slow and expensive (bankruptcy filing in the UK costs £850).

Equally as important as a well-functioning insolvency regime is the ability of households to access timely and appropriate financial advice. The UK suffers from a lack of free, independent financial advice for lower-income households. A large fee-charging advice sector skews advice towards long-term debt management plans (with high upfront and continuing monthly fees).

A structural problem with financial advice in the UK is that the incentives of the fee-charging providers of advice are incompatible with the best interests of households with unpayable debts, which is often fresh-start insolvency. Providers of advice have little incentive to recommend bankruptcy, as it offers less opportunity for revenue streams for them (such as monthly fees).

Hence the current situation facing households in the UK reinforces the need for widespread access to impartial, free financial advice (Disney et al, 2015). A broadly beneficial policy intervention at the current time would be additional funding for free-to-client debt advice.

What further research is going on?

John Gathergood and Neil Stewart are starting a UKRI Rapid Response grant-funded project ‘Real-time evaluation of the effects of Covid-19 and policy responses on consumer and small business finances’ in conjunction with the UK Financial Conduct Authority and retail banks.
Paolo Surico and co-authors are developing an extensive series of studies of the effects of the crisis on household finances.