January 1, 2009: The Magic Date to Fix the Housing Crisis. Yes, We Can.
Diseases desperate grown
By desperate appliances are reliev’d;
Or, not at all. (Hamlet, IV,iii)
To solve our economic crisis, I have previously written about the need for massive public investments. ("Wanted: A Good Keynesian. Massive Public Investment Will Fix the Economy", October 13, 2008; "McCain’s Plan: Not Just the Worst Plan, But the Dumbest Idea Since Putin Reared His Head", October 15, 2008).
President Obama is addressing the demand side. He is outlining a plan to create 2.5 million new jobs by 2011. That is necessary, but not sufficient. And, it will take some time to get those projects launched to put people and companies to work and to thus stop the slide of the economy, and restore consumer confidence.
In the meantime we need to fix the housing crisis. Consumer confidence will then begin to return. With that, a virtuous cycle of increased demand and business activity can stop the economic tailspin. When the massive public investments actually kick in, the economy will already have begun to recover. The US will be able to lead the world out of a global depression.
Fixing the Housing Crisis without Cost. Mortgage-based securities (MBS) are financial instruments that combine 100s or 1000s of mortgages into a single asset. An MBS can be bought or sold just like any bond. The banks started getting into trouble when defaults occurred in some of the mortgages in an MBS, causing the MBS’s value to decline. They then had to write down (take the loss) of the reduced value of the MBS and their asset base thus contracted, putting the banks in precarious positions.
In a month that very problem can be an opportunity for economic revival. The basic concept is that when the bank writes down the MBS, it should write down the underlying mortgages. It can do that without cost. It is fair and respects moral hazard. Here’s how it works.
Most companies have fiscal years that end December 31. Whatever losses they have suffered in that year become ancient history on January 1, slightly more than one month from today.
An example will make the solution easier to understand. Suppose a bank paid $100 million in 2005 for an MBS. $100 million of cash went out, and an asset worth $100 million was acquired. The net, at the time, was zero and life was uncomplicated.
Fast-forward to 2008. Some of the mortgages in the MBS were no longer performing, and thus the value of the asset declined dramatically. Let us assume that what was worth $100 million, is now valued at $20 million.
Thus, in 2008, the company had an $80 million loss. That was not a loss of any more cash (the cash was paid in 2005), but it was a loss of the value of the asset, and thus an opportunity to raise the cash if they decided to sell the asset. Since it was deemed permanently impaired, the bank took an $80 million accounting loss in 2008.
Come January 1, however, the bank now has a $20 million asset. The loss was suffered last year. Its total assets are decreased from 2008, but there is no further "loss" involved with holding it.
Since January 1 clears the deck, the banks are in the position to reset the mortgages underlying them without any further loss to the bank.
For example, suppose you had a mortgage of $500,000 that was part of this MBS and you were paying $2000 per month. Because the value of the MBS’s including your mortgage is now 80% lower, your mortgage is, on average, worth only $100,000.
The bank is, therefore, in a position to come to you and reset your principal, and the associated payments, to service a $100,000 mortgage instead of $500,000 without any loss to the bank. Your $2000 monthly payments would become closer to $400 per month. Now, you could better afford to make your payments, will have more disposable income left each month, and the bank suffers no further loss starting. Indeed, the reset reduces the danger of default, and thus enhances the value of the asset.
Suppose, further, that your home that was purchased for $500,000 (assuming no-money down, but it could be more) in 2005 is now worth $300,000 because of the 40% decline of housing prices. Before the reset you had $200,000 of negative equity, paying on a $500,000 home worth only $300,000. In financial slang, you were $200,000 "underwater". Under the reset provisions outlined above, however, you are no longer "underwater" because you are now paying on a $100,000 mortgage for a $300,000 home. You have $200,000 positive equity in your home and are no longer a distressed homeowner. Your "consumer confidence" is likely to be much higher.
In a nutshell if the bank has written down the MBS, it should reset the underlying mortgages as well.
This is all costless to the banks. It is a windfall for homeowners. But, what about "fairness" and "moral hazard"?
Fairness has been raised in the following context: is it fair for one person who took out a loan he cannot, or will not, pay, get a break when others who have behaved more prudently do not? Moral hazard deals with consequences–if there is no penalty for wrong or stupid decisions, then there is no incentive for responsible behavior, and another round of risky actions may be encouraged.
Both issues can be addressed by the same analysis. Let us be clear. The reset occurs for all the mortgages in the MBS, not just those that are not performing. No action of any particular homeowner, therefore, triggered the "windfall" for himself. Rather, it was the greed-cleverness-creativity of the financial system that decided these MBSs were a great idea, and their derivatives such as credit default obligations that were an even more brilliant idea, that created the house-of-cards that collapsed as one part wobbled.
Many of those who created these instruments have indeed been punished. Financial institutions will think twice (or thrice) about the downstream implications of creating and/or purchasing future complicated instruments. That is, moral hazard will have worked. Indeed, it is not too much of a stretch to argue that some of the defaults will have been due either to negative equity or to the economic downturn, or both, and both can trace some of their roots to these financial instruments.
What about fairness? Under the reset proposal there is no penalty or reward for one’s own behavior. Instead, you are a victim or beneficiary of the MBS into which your mortgage happens to have been aggregated. You had no more to do with that outcome than with my being able to dunk a basketball and you not, or that a piece of property you bought was found to have gold on it. Some people will be better off, some will be much better off, and some will be no worse off. And, who falls into what category will be a matter of chance. Economic theory, "Pareto optimality", tells us that a solution in which some are better off, and no one worse off, is a superior outcome.
There is another wrinkle could be included to provide some upside to the bank. This would be important if the bank also received taxpayer money as an investment under the TARP, so the taxpayer might benefit as well by strengthening the banks’ potential gains. Suppose, in conjunction with the mortgage reset, the bank took some percentage equity interest in the dwelling so that, when you sell it, part of the price above expenses would go to the bank. That would provide some upside above the reset for the bank, and thus for the taxpayer-owned equity in the bank.
How can this be accomplished? It is one thing to show how this does not cost the bank anything other than administrative costs. But, companies do not spend time on endeavors to break-even, but rather to make money. No individual bank has an incentive to initiate these actions just because, if others did it as well, it would be good for the country.
Government action is required, either through incentives or directives. In these times, and with these stakes, the government should use whatever powers it has to get this done.
The financial schemes that enriched the banks resulted in taxpayers having to bail them out. But, who are the taxpayers? Many are homeowners. So, the homeowners who are bailing out the banks will receive a return "favor" from the banks by the mortgage resets. Like the bailout, the mortgage reset will fix another systemic risk, collapsing consumer confidence.
January 1, 2009. It is about time.
Who would object?