A Simple Bailout Plan for Housing and the U.S. Economy
Now that everybody is busy the budget and the debt limit, we are forgetting that the single clear and present danger for the US economy is the state of housing. As the economy is slowing again, it threatens to trigger more foreclosures. In turn, this would further damage banks' balance sheets and prevent already gun-shy banks from finally loosening credit. If banks decided to hoard even more reserves, it would have disastrous consequences for economic growth and job creation. Yet, this is nothing new: it has been the situation for two years and nothing was done then and since. Worse, it would be surprising if anything intelligent gets done now. Both parties have lost even the slightest perspective on the reasons that brought us here. What would make you think that once August 2nd passes, they will work together to resolve the situation? Some economists, such as Martin, had identified the problem in the fall of 2008. His article, "How to Save an ‘Underwater’ Mortgage", published in the Wall Street Journal in August 2009 was his third attempt to influence policy makers in giving a break to home owners; his first attempt had been made in September 2008 when it was still early in the game. Feldstein also went on Charlie Rose in early 2009 to plead his case with Nobel laureate Joseph Stiglitz who lent him support for the proposal. But to no avail. In spite of the influence of the former head of the Council of Economic Advisers from 1982 to 1984 under President Reagan and former president of the National Bureau of Economic Research, Washington was not listening.
To be fair, the Administrations - both Bush's and Obama's have come up with some loan modification programs to deal with the issue. However, they were so poorly designed and lacked so much in scope that they failed to gain any momentum. To the surprise of many, the Obama administration continued to pamper bankers and concentrate their efforts on saving the banking sector rather than home owners; blind to the fact that the collapse of housing sector is at the origin of the problems that banks had and still have today. Why is the idea of savings households as a way of getting banks out of trouble such a bad proposition? Is it because Washington is too influenced by the ideas of Wall Street?
Yet, read the several articles in which Feldstein outlines his bailout plan and will quickly come to the conclusion that in spite of his bang-on diagnostic of the situation and his good intentions, his proposal suffered from some important drawbacks that limit its application: It would have required changing the law, it reduced monthly mortgage payments very little, it affected only the worst-case borrowers, it would have taken a while to implement and it would have required that banks take some write offs (which, of course, they were very reluctant to do at the time). Finally, it also hinged on the assumption that the parties to any modification could agree on the value of the homes being targeted by the plan; probably the biggest problem when values were falling fast in the Fall of 2008 and the Spring of 2009.
I am proposing below a bailout plan for both housing and banks that dodges all of these limitations. Let me know what you think.
"In the Spring of 2009, US Treasury Secretary Geithner unveiled his plan to save the economy and the banking system. However, the plan still fails to fully acknowledge the negative dynamics of the still deteriorating housing market on the success of his proposal. Admittedly, the government also took steps to encourage lenders to modify loans for people in foreclosure or at risk of foreclosure. However, difficulties in determining who qualifies, and for which amount, will likely severely limit the scope of that proposal. Moreover, the government also proposed that private investors buy toxic assets from banks using government subsidies. However, finding common ground to establish a price for the assets has proven difficult. Equity issues have also been raised by many who fear that the scheme will enrich hedge funds and private equity managers.
"Here is an alternative: Make an attractive offer to all homeowners but tweak the incentives so as to attract only those needing help. Specifically, offer to all existing homeowners (of owner-occupied homes), mortgage relief up to 33% of the value of their mortgage in exchange for the same percentage of equity in their home. As a virtue of being offered to everyone, all individual decisions to accept or refuse the government's offer would provide much needed information about the quality of individual loans. This information would represent the Holly Grail for the financial sector as it would allow banks and investors to finally put a fair value on mortgage pools.
"The opportunity for each individual homeowners to "sell" a portion of their home to the government (in a debt-equity swap fashion) also offers the following: truly significant mortgage payment reductions for borrowers, some breathing room to support consumption and a huge quality improvement in banks' balance sheets. If designed as a simple mortgage pre-payment program, such a plan could be implemented by motivated banking loan officers within six months.
"Consider a homeowner who bought a house in 2006 for $250,000 with a $240,000 mortgage ($10,000 down payment). This homeowner may now be contemplating foreclosure as the value of his home is likely closer to $200,000 today and/or his monthly mortgage payments too high. Under the proposed plan, the homeowner could choose to accept mortgage relief for $60,000 (25% of the original $240,000 mortgage) in exchange for a 25% equity stake in his home. By selling the property for $300,000 in 7 years (assuming a reasonable 6% annual nominal appreciation), the homeowner's share of the house would then be $225,000; $35,000 above the $180,000 modified mortgage. Not bad for a $10,000 initial investment, largely under water today! The government would get back $75,000; enough to recoup its capital and protect against inflation.
"A simple example would also convince the reader that the offer would be rejected by homeowners with enough home equity. This means that each individual decision to reject the government’s offer would also send a strong signal to the market as to who would repay their mortgages in full without government help.
"In the previous example, if the house were to be sold early for $220,000, the outstanding bank mortgage ($180,000) would be repaid first to the bank and the balance of the proceeds from the sale ($40,000+) would go directly to the restructuring government entity. The balance of government equity ($20,000-) would then be converted into a fully recourse loan yielding 3%. The conversion of the equity into a full recourse loan would provide a disincentive for the owner to sell his/her house early or to enter foreclosure. This would help stabilize the housing market by keeping more homes off the market until prices have appreciated enough. Moreover, the full recourse conversion would also deter borrowers with no prospect of ever repaying their loans from entering the swap agreement; providing much needed information about which loans which should be definitely written off. Moreover, the relief effort would focus on making sure that only troubled, but salvageable, borrowers are turned into viable homeowners.
"Assuming an average mortgage relief of $60,000 for the 12 million homeowners with little or marginally negative equity today, the total cost of the plan would be $720 billion. However, as we saw, most of this money could be recovered, once the homes are sold. Moreover, if banks were forced to first write down each mortgage by 5% before being entitled to the debt-equity swap money, the initial funding for the scheme and the ultimate cost to taxpayers could be substantially reduced.
"Allocating the bail-out money directly to American homeowners would be a politically superior strategy than buying up banks or let hedge funds and private equity investors buy the toxic waste; not least because it would allow many families to stay in their home. Banks, on the other hand, would be much closer to assessing their loan portfolios at values that might actually reflect their true worth under more favourable market conditions. This prospect alone would promote the strong support of banks which in turn would speed up implementation and thus could help avert bank nationalization.
"By taking an equity position in homes, the government insures a certain fairness as it extracts something (i.e. equity) from over-leveraged homeowners, without passing moral judgment, rather than trying to determine administratively who should get it. Finally, as the leverage is transferred from over-leveraged owners to the government most able to support it, the risk to the economy is also considerably reduced."
Isn't this simple enough? This is not a new idea. I wrote this plan in the Fall of 2008, just after the collapse of the market in late October that year. See my entry I tried to get it published in the Winter of 2009 but no newspaper would touch it. I finally published this short version on August 12th 2009 in The Sceptical Market Observer. I even talked about it, during a visit at the White House, to the Chief economist of the Council of Economic Advisors a little later.