Wednesday, October 01, 2008

Bail out Main Street, not Wall Street

The $700 billion Paulson plan is too expensive and fixes the wrong end of the problem.  A better solution is obvious: bail out the mortgages that are going into default, rather than bailing out the banks that are capitalized by derivatives of those mortgages.

Bailing out the mortgages themselves is much cheaper (around $200 billion), directly eases the problems of millions of homeowners, and should fix the bank's capitalization problems.

Now, if it doesn't fix the capitalization problems, that means there is a lot more bad debt floating around than just these subprime mortgages.  And if this other debt is the problem, let's get that problem front and center so we can deal with it.

Some background:  The subprime crisis is essentially this:
  • Millions of people in the U.S. bought houses more expensive than they could afford, on the assumption that the rise in the price of the house would help them pay for the house.
  • Those people accepted mortgages with initally low rates, that then increase after a period of time.  They figured that before the rates increased, they would either get a job that paid better, or refinance the house based on a higher assessed value which would give them a larger equity stake and therefore make it possible to get a loan with a lower interest rate.
  • Housing prices are not rising, and those people are unable to refinance and don't have a better job.  When the interest rate rises, they can't pay the increased bill and fall behind on their mortgage payments.
After 10 years of excessive spending on houses, and excessive building of expensive houses, the US has too many expensive houses.  The house price collapse will not be resolved until the US economy has grown enough folks with enough income to afford those houses.  My guess is this will take about a decade.

In the interim, we cannot allow those extra expensive houses to go unoccupied.  Unoccupied houses fall apart, and so they lose value quickly.  This loss will be borne by the large institutions in our economy and will be a net drag on our net asset growth.  Under the Paulson plan, the government will buy derivatives of these mortgages and these losses will pass to the taxpayer.

So, the houses must remain occupied, and we do not have enough people who can afford them to occupy them.  Until we grow those folks, the best people to occupy those houses is the people who are living in them now.  I have a plan to keep them there, detailed below.

The financial crisis is an extension of the subprime crisis:
  • Banks have been converting bundles of mortgages into mortgage-backed equities, and selling those.  Many institutions now own these assets.
  • The value of those equities depends on the number of mortgages within them that default.
  • The value was initially determined by making assumptions about the usual number of mortgage defaults.  Side note: some mortgage-backed equities are guaranteed, so that the risk of many defaults is seperated out into another security.  That does not change the problem, only who owns it.
  • Because the subprime crisis is surprising, nobody is comfortable estimating the number of mortgage defaults any more, and so the value of these equities is not well known.  Their value is plummeting for two reasons:
    • More risk means less value.
    • Banks are trying to sell these MBEs, but nobody is buying.
  • Banks are required to have a dollar of capital for every 12 dollars they loan out.  When the value of their assets drops, they have to sell some of their loans (packaged as mortgage-backed equities) to generate more capital.
  • So, selling MBEs causes the value of the MBEs still held to drop, which forces the bank to sell more MBEs.  The feedback loop is driving the capitalization of the banks below the legal requirements, which causes the banks to fail.
Paulson's plan is to have a U.S. government agency buy $700 billion of mortgage backed assets at some "fair" price.  This price will set a floor on the valuations of the assets owned by banks, so that they don't have to sell so many MBEs, and it will give them the cash they need to improve their asset positions to the point where they can loan money again.

The Paulson plan will fix the Wall Street problem, but it does not address the Main Street problem, that is, the mortgage defaults, except that in avoiding a recession it will reduce the number of mortgage defaults from people losing their jobs.

The alternative is to fix the Main Street problem directly.  If the government guarantees that only the expected number of mortgage defaults happen, then the MBE will have known values, which should also put a floor on the valuation of the bank's held assets and similarly ward off the credit crunch.

Here is how the government makes that guarantee.  Let's say that Harry has an adjustable-rate mortgage which just increased its rate, and he can't afford it.  His original 10% equity in the house is down to 5%.  Ordinarily he would go into default, and at some point the bank would reposess the house and evict him, and then sell the house.  We don't want that to happen because either the house will go vacant for a long period of time, during which it will deteriorate and lose value, or the bank will sell it for a song and lose a great deal of money, causing the bank to go bankrupt.

Instead, the government steps in and offers Harry the following deal:
  • The government buys 25% of the house from Harry.
  • Harry now refinances his 75% of the house.
    • He now has 6.66% equity in his smaller share of the house.
    • His loan amount is 74% of what it was, so his payments are proportionally smaller.
  • At some point in the next 10 years, presumably after the housing market has worked through its excess inventory, Harry gets a one-year notice from the government that he needs to either buy back the government's 25% or sell the house.  He can sell at any earlier time if he likes.
So, how much cash would the government have to invest with this plan?  Suppose the number of subprime mortgages is 9 million, and 25% of those are in serious delinquincy.  Suppose the average value of those houses was $320,000.  For the government to purchase a 25% stake in all of those would cost $180 billion.  And note that this is an investment.  After ten years or so, we should expect to see most of that money back, perhaps with some gain.

Why is my plan cheaper than Paulson's plan?  The primary difference is that my plan keeps people in their houses by purchasing a portion of the house's value.  Paulson's plan requires the government to buy the full value of the mortgage.  What Paulson's plan does not detail out is that the government will be stuck with the loss when the owners default on the mortgage and then the house is repossessed and sold for a loss.


  1. You know, that’s not a bad idea. Would be like a massive expansion of Section 8. One quick comment on the underlying problem though: as I understand it, the bigger problem is that people bought too high, with too little money down, and now that prices have dropped they owe more than the house is worth – which is a huge credit problem for the resold mortgage, even if the borrower himself hasn’t defaulted and isn’t going to. So it’s not just that the price hasn’t risen or that they can’t refinance (the interest-only ARM is an especially foolish footnote in this mess, but not, I don’t think, the underlying cause), it’s that prices have fallen – by 10-30% from the bubble’s peak a year or two ago. That’ll take more than a decade to work through. In past real estate bubbles, prices in the frothiest markets crashed, then stayed flat for a decade or more as excess capacity gradually fell, and only then started to rise again.

    Regarding the Paulson plan, I have no idea whether it makes sense. I’d really love to see some of the analysis that’s backing up these plans. But I suspect that some kind of government intervention in the financial system is necessary, even if the real estate market is buoyed as you suggest. Most of it may take the form of orderly liquidation a la Bear or WaMu; those firms were wiped out rather than bailed out, but (crucially) they were left functional. But even if it’s not a true bailout, it would still cost money.

    This whole thing reminds me of the California energy crisis: when consumers are unable to respond to real price signals, it’s often the market intermediaries who get stuck with the mismatch between supply and demand. In the California case, it was the political decision to let the intermediaries fail (that is, to let PG&E and Southern Cal Edison go bankrupt) that turned the crisis into a catastrophe. I wouldn’t want that to happen to the national financial system.

    You’re right about the cost of the underlying problem though. The actual real estate price drop seems to be “only” a few hundred billion. That may be why Congress wants to limit the initial payout, and Paulson seems to be okay with that; the $700 billion is apparently way more than he thinks he needs (but he asked for it anyway of course).


  2. Iain:

    I like your plan for a number of reasons, especially the fact that it protects the very assets that are underlying the mortgages - the physical condition of the building called a house and the physical and mental condition of the occupants of that building that make it a home.

    Both are important parts of the value of a mortgage - if the building falls apart, no one will want to buy it. If the people living in the building are healthy and determined to maintain it, the mortgage can be repaid even if the building does not change hands.

    One more thought that I have wanted to share with someone - if part of the underlying problem is a supply and demand issue, with too many homes and not enough buyers, why in the world are so many Americans so willing to close our borders and keep out potential buyers?

    Why is the government raiding places of employment and arresting working people who just may be making payments on a home, just because they broke a few rules in coming to America and trying to gain economic prosperity?

    I know there are people who are offended by those who "broke the law", but there are a great many of us who would not be here now if the laws had always been as restrictive as they are today. One of the reasons that immigration laws were pretty lax in the 1800s and early 1900s was that the leaders in that era recognized a fundamental economic fact - human beings are valuable resources that help make an economy strong.