Simple Solutions For America #1: Fixing the Mortgage Market
We’ve spent a lot of time talking about what went wrong, now it’s time to start talking about how to fix things. Since the current financial crisis was sparked by the meltdown of mortgages (the so-called subprime crisis, though it extends far past subprime) lets see what a liberal government would do to fix the problem.
Right now what’s happening is Ben is taking the distressed mortgages, along with various other toxic waste paper, and lending the banks and brokerages treasuries in exchange. This is a government bailout by another name, but it’s one where the government is paying essentially full price for the mortgages even though most of them are worth far, far less than that and one that provides no relief at all to homeowners. It keeps the banks in business, even if not solvent, but does nothing to put a floor underneath potential losses. All it does is transfer those losses from company spreadsheets to the Feds. Granted, the fed can always swap those back, but then most of those companies would wind up as insolvent.
What is needed is to provide a mark to market price. Right now you basically can’t move mortgage backed securities, there is no market. When you think about it, that’s awfully strange, after all, at the end of the day a mortgage is backed by a house and the property it sits on. In some cases, that house may be worthless, but in most cases it’s worth something. Even in the most overheated areas of the country, I would expect housing prices to drop by no more than 50%. In most areas somewhere between 20% to 40% should occur. To put it another way, one can reasonably expect that the correction will take back most of what the bubble gave, and a simple way to figure out a baseline is to look at the median price increase in a particular county since 2001. It may fall to slightly less than that, or slightly more, but it makes a decent baseline.
So here’s what a liberal government does. It provides real market clearing to the market by offering to buy mortgages, only in blocks, at a discount. Not to lend, as the Fed has been, but buy. It sets the price at approximately what the land would have been worth in 2001. It converts each and every mortgage it buys into a simple fixed rate mortgage with a nominal value for the property equal to what it bought the mortgage for plus ten percent and it lets the property owner choose a 10, 20, 30 or 50 year term for the mortgage as long as the monthly payments are no more than 1/3 of the owner’s income. If you can’t afford the payment on 1/3rd of your household income the duration of your mortgage gets kicked up until you can. No other loans can be taken against the house until the mortgage is paid off and no lump payments are allowed so that finance companies can’t come in later and offer to pay of mortgages so folks can do foolish things. (If you get involved in this program you obviously did foolish things and you give up the right to control a certain part of your own finances. Don’t like it? We’ll let you opt out and deal with the bank yourself.)
You allow only mortgages on primary occupancies residences to get into this program. Some arrangements will have to be made for situation with multiple mortgages and so on, but those details can be worked out. The mortgage will be transferable in event of a sale. For the first half of the mortgage duration, if there the house is sold for more than the value of the original mortgage (the 2001 price) then the government gets half the upside.
What are the advantages of this program?
It sets a floor under mortgage prices and creates a market for them. They are now worth X. That allows banks, hedge funds, brokerage houses and others to actually put a mark to market value on them and have a good idea of how much debt they’re carrying due to those securities.
The government makes a profit over the life of the mortgages. This is important. If the government is going to bail out people, there’s no reason why the government shouldn’t come out ahead in the long run. This is only fair to taxpayers, who will take on a burden from the original payments but will see a benefit from it in the future.
Lenders take a loss. They should. Moral hazard must apply to lenders who lend more than their borrowers can repay. The government should not be expected to be the banks leg-breakers beyond a certain point and that point is far gone when you’re getting into liars loans, balloon mortgages and a business model that assumed that housing prices would never drop so they was no risk. There was risk, the lenders made a bad bet, they should lose money.
Property owners take a substantial loss in property price and they give up half the upside of any price increases for some time. Again, people who have acted foolishly should not be bailed out without any cost and moral hazard applies to individuals as well as companies.
There are a couple disadvantages as well. US monetary stock is based, to a large degree, on the value of the US’s housing stock. This will fast forward deflationary pressures, doing in a couple years what would have taken 5 or 6 to play out normally. However, given that there are strong inflationary pressures at the current time, and because it sets a floor under property deflation, the risk is probably worth it. Nonetheless, it is a risk.
In addition, this will shock property taxes, hard and fast. The Federal government will need to provide some monetary support to municipalities for a few years. This can be paid for out of the income from mortgage payments. And really, municipalities were in a pile of pain anyway. If the offsetting payments are sufficient, they could actually come out ahead.
Those risks are worth the candle. The current Fed bailout does nothing to help property holders, does nothing to create a real market clearing price and puts taxpayers completely on the hook for uncertain amounts of massive losses. This plan creates a market, spread the pain but helps both investors and property owners and it will, odds on, actually wind up earning the government a profit.
But note something important; it’s the sort of plan that can only be done by Congress, with the President signing it into law. It can’t be done by the Fed alone. And that means that for sensible, simple solutions like this to be enacted we probably need both a new President, and a new Congress.