Solve the Credit Crisis With No Bailout

Published on
the San Francisco Chronicle

Solve the Credit Crisis With No Bailout

Steven Wallman

We're in trouble. Although markets and Wall Street institutions are melting down (with the occasional bounce back), the central issue is the real economy, that is, Main Street. With banks and others holding mortgage-backed securities of unknown and sometimes dubious value, credit has evaporated. Banks won't loan to each other or others because they don't know each others' real worth. Companies that need to borrow to expand, or just not contract, start having trouble getting loans. Everyone wants clearly valued collateral, which is hard to come by when you don't know what something's worth. Without credit lubricating the economy, it seizes up.

The proposal that died Monday in Congress, and likely will re-emerge, was one proposal that predictably sought to resolve symptoms. It has the government buying mortgage-backed securities from the firms who created them or now own them. It's viewed as a means to buy these securities on the cheap, and hold them until the market recovers. That way supposedly the government could even make money. More likely though, the securities won't be bought at their true current fair market value because, if they were, the banks selling them would incur huge losses. They'd still be weak, not strong. Instead, the government will pay more for the securities than they are worth today, as a means to help recapitalize the banks. The whole process of buying and selling securities is what Wall Street knows how to do. Some might say it takes care of the lobbyists and the rich. Bottom line, it's a proposal that could work. But it's not the best.

Instead, thinking folks might say why not solve the underlying problem - the cause - not the symptom? The root cause of the crisis, simply put, is homeowners' mortgage delinquencies and foreclosures. When the mortgages backing securities suffer, those mortgage-backed securities suffer, and so do the banks holding them. But, if the government buys the mortgage-backed securities, that does nothing - absolutely nothing - to make the underlying mortgages more valuable or more likely to be paid, stabilize home prices or help homeowners in distress. It does nothing - absolutely nothing - to directly benefit the real economy.

But another proposal does. Use the $700 billion on the table and stabilize housing. Make that money (actually only a fraction would be needed) available to homeowners who live in their homes (not speculators). Here's how: Offer any financial institution (or require it, although no financial institution in its right mind would refuse the offer anyway), that owns a mortgage of an owner-occupied home in distress, to provide that homeowner, in lieu of any penalties or foreclosure, a government guarantee of the current or missed payments under the mortgage. If the homeowner agrees to have the government take over the payments, the financial institution would inform the government, the government would make the payments, and the homeowner in exchange would sign a note agreeing to repay the government some years in the future (say, 10), with interest at the same rate currently required under the homeowner's mortgage.

A few observations: First, the process is simple; it could be implemented without huge new government programs. It relies on regulated and monitored entities who know how to process these transactions, and there is no sudden time pressure to buy billions of dollars of anything over the course of a few weeks.

Second, it is voluntary on the part of the homeowner. No one is forced to do anything he or she doesn't want to do, although the incentives are pretty clear. The bank will want to offer, quickly and efficiently, the government's help to the homeowner, and you'd think in most cases the homeowner will want to accept it.

Third, no one gets a free ride. The existing mortgage remains unaffected (so no one has to agree to change existing agreements), but it is no longer in distress. The real economic terms of the mortgage are in essence reformed to allow the homeowner to work his or her way out of distress, or for the value of the home ultimately to recover enough for it to be refinanced or sold with some equity.

Fourth, offering this program immediately stops the cycle of foreclosures and value destruction currently underway (which buying mortgage-backed securities does not).

Fifth, as important as the above, it will force an upwards revaluation of the mortgage-backed securities as they will now have, in essence, a government guarantee for any non-performing part, thereby immediately restoring capital and liquidity to the financial system. In fact, those securities may now even trade above par as any priced-in default risk that existed at issuance will now be eliminated.

Sixth, and yes, the homeowner would be required eventually to repay the loan - an obligation that will come due in the relatively distant future. To compensate the government further, should it feel it needs further compensation than saving millions of people from foreclosure and saving the global economy, the homeowner could be required to share in some of the upside upon any future sale of the house.

All the above would be documented over time with a standard note and mortgage-type procedure. The homeowner would have granted a second lien to the government and, if deemed necessary, transferred some of the future equity value in the house to the government (the taxpayers) in exchange for not losing the house now. (The amount of sharing could simply be formulaic - for example, the loan being made by the government could carry an interest rate of say, 2 percent, over the mortgage rate, with the sharing comprised of that part of the equity value needed to pay off the higher interest rate; that amount will be forgiven if there is no such equity.)

The homeowner has an incentive to pay off the government loan and refinance as soon as practicable because the government rate, in essence, will eat into the potential equity in the home - so everyone has an incentive to act responsibly.

On the downside, in the event the home never appreciates enough to pay off the government note (which will be paying off the primary mortgage), then the taxpayers may lose some value if the homeowner does not step up (but not a loss anything like what's being proposed now) and there is a lot of time to allow the economy and its home-owning citizens to recover. The government will have years to determine if it wants to extend payment schedules, or take other actions to mitigate any issues.

Overall, this is a simple proposal that actually works. No one is bailed out, although the government accepts some risk. The system re-lubricates and the global economy is saved. Little money is actually needed to implement this, and if the economy recovers quickly enough with this proposal in place, home values may stabilize enough for conventional refinancing to work, so the government would actually pay very little. There is a win for everyone in this - if only you can get past the politics.


Steven Wallman was a commissioner of the Securities and Exchange Commission under President Bill Clinton. He is CEO of FOLIOfn, Inc. a financial services company that owns no mortgage-backed securities or mortgages, and never created, issued or sold one.

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