Consilience Productions

« Market Fear and Panic. | Main | Income Disparity in America. »

Solutions to the economic meltdown.
October 11, 2008 12:40 PM

Supposedly the smart guys are in charge in Washington, DC, right? Ben Bernanke, the Fed Chairman, who is an expert in the Great Depression, has been firing away at the problem, along with Henry Paulson, the Treasury Secretary. And yet the markets keep cratering.

Are they listening to the right guys, i.e. economists? These policy wonks spend their time trying to figure out solutions to great problems, so you'd think that the Washington policy-makers would be consulting them these days. Have they spoken with Luigi Zingales from the University of Chicago?

He's got a Plan B that makes a lot of sense:

After pointing a gun to the head of Congress, threatening a financial meltdown in case his plan was not approved, Treasury Secretary Hank Paulson has finally arrived at the only logical conclusion: his plan will not work.

Desperate for a Plan B, Paulson is slowly warming to the suggestion of many economists: inject some equity into the banking system. Unfortunately, it is too little and too late. The confidence crisis currently affecting the financial system is so severe that only a massive infusion of equity capital can reassure the market that the major banks will not fail, recreating the confidence for banks to lend to each other. The piecemeal approach of 100 billion today, 100 billion tomorrow used with AIG will not work. It will only eat up the money, without achieving the desired effect -- without reassuring the market that the worst is over. Simply stated, nothing short of a 5% increase in the equity capital of the banking system will do the trick. We are talking about 600 billion. Unfortunately, even if the government is willing to spend this kind of money, there are three problems.

He then discusses the three problems before focusing on the best solution:

We need a different solution: a Plan B. A plan that minimizes the money the Government uses in bailing out Wall Street and Main Street to save our precious dollars for a stimulus package, which will be essential to restarting the economy.

Suppose that you bought a house in California in 2006. You paid $400,000 with only 5% down. Unfortunately, during the last two years the value of your house dropped by 30%; thus, you now find yourself with a mortgage worth $380,000 and a house worth $280,000. Even if you can afford your monthly payment (and you probably cannot), why should you struggle to pay the mortgage when walking away will save you $100,000, more than most people can save in a lifetime? However, when the homeowner walks away, the mortgage holder does not recover $280,000. The foreclosure process takes some time during which the house is not properly maintained and further deteriorates in value. The recovery rate in standard mortgage foreclosures (which will not take place in the middle of the worst crisis since the Great Depression) is 50 cents per dollar of the mortgage. I am generous in estimating that under the current conditions it might recover 50 cents per dollar of the appraised value of the house; right now, it is only 37 cents per dollar of the mortgage, which given a house appraised at $280,000 equals only $140,000 for the mortgage holder. In other words, foreclosing is costly for both the borrower and the lender. The mortgage holder gains only half of what is lost by the homeowners, due to what we economists call underinvestment: the failure to maintain the house.

In the old days, when the mortgage was granted by your local bank, there was a simple solution to this tremendous inefficiency. The bank forgave part of your mortgage;let’s say 30%. This creates a small positive equity value—an incentive—for you to stay. Since you stay and maintain the house, the bank gets its $266,000 dollars of the new debt back, which trumps the $140,000 that it was getting through foreclosure.

Unfortunately, this win-win solution is not possible today. Your mortgage has been sold and repackaged in an asset-backed security pool and sold in tranches with different priorities. There is disagreement on who has the right to renegotiate and renegotiation might require the agreement of at least 60% of the debt holders, who are spread throughout the globe. This is not going to happen. Furthermore, unlike your local bank, distant debt holders cannot tell whether you are a good borrower who has been unlucky or somebody just trying to take advantage of the lender. In doubt, they do not want to cut the debt for fear that even the homeowners who can easily afford their mortgage will ask for debt forgiveness.

Here is where government intervention can help. Instead of pouring money to either side, the government should provide a standardized way to re-negotiate; one that is both fast and fair. Here is my proposal.

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4% in the last two years.

And how is this implemented?

Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level. Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property. Exactly like in my hypothetical example above.

In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder. It seems a strange contract, but Stanford University successfully implemented a similar arrangement for its faculty: the university financed part of the house purchase in exchange for a fraction of the appreciation value at the time of exit.

The reason for this sharing of the benefits is twofold. On the one hand, it makes the renegotiation less appealing to the homeowners, making it unattractive to those not in need of it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up 50% of the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

Since the option to renegotiate offered by the American Housing Rescue & Foreclosure Prevention Act does not seem to have been stimulus enough, this re­contracting will be forced on lenders, but it will be given as an option to homeowners, who will have to announce their intention in a relatively brief period of time.

The great benefit of this program is that provides relief to distressed homeowners at no cost to the Federal government and at the minimum possible cost for the mortgage holders. The other great benefit is that it will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions' balance sheets. But it will not resolve the problem of severe undercapitalization that these institutions are currently facing. For this we need the second part of the plan.

Let's hope that the guys in Washington are finally talking to these economists, because they are making a lot of sense right now...

Read the entire article...

Join the discussion: Comments (0) | TrackBack (0) | Email Link to a Friend
Permalink to post: http://www.cslproductions.org/money/talk/archives/000700.shtml
Receive an email whenever this MONEY blog is updated:   Subscribe Here!
Tags: , , ,

Share | | Subscribe




Add your comment

Name (required)
Email
Website
Remember personal info? Yes   No
Comments

home | music | democracy | earth | money | projects | about | contact

Site design by Matthew Fries | © 2003-23 Consilience Productions. All Rights Reserved.
Consilience Productions, Inc. is a 501(c)(3) non-profit organization.
All contributions are fully tax deductible.

Support the "dialogue BEYOND music!"

Because broad and informed public participation is the bedrock of a free, democratic, and civil society, your generous donation will help increase participation in the process of social change. 100% tax deductible.
Thank you!


SEARCH OUR SITE:

Co-op America Seal of Approval  Global Voices - The world is talking, are you listening?