Friday, September 26, 2008

A Simpler Plan

I missed a chance to be on CNN again (gosh darn it!) in order to do an hour long show on NPR Oregon with economist Brad DeLong. The show got me thinking about a simpler way to fix the current problem than doing reverse auctions of toxic assets. Simpler economically and politically.

Here it is:

Any American with a mortgage can trade it in for a government one for the same principal amount, at a fixed 7 percent interest per annum, for any term up to 50 years. In return, the government will pay off the existing mortgage with a Treasury bond with the same market value and maturity as the mortgage it is replacing. The lender can then hold the bond on its balance sheet until maturity, sell it in the market, use it as collateral for a loan, strip and sell the coupons, etc.

Because the government can at present borrow at far less than 7 percent, and because it can easily garnish wages using existing (tax) infrastructure, this will not be a bailout but rather a source of revenue which can be applied to pay down the national debt. (See my blog entry below about the colonial loan offices, which prove that governments can and have profited by providing mortgages to citizens.) The two keys are extending the term of the mortgage to the point that homeowners can afford to make the payment and making sure that borrowers don't default simply because they are "in the bucket" (have negative equity) by using the coercive power of the state. Anyone who prefers to default rather than take the government loan may do so, at which point the lienholders (new owners) may, if they wish, mortgage the property to the government for the amount they are owed. (Or they can resell or rent it, as they prefer.)

The plan is also much more palatable politically than the current administration plan, for several reasons:

a) as noted above, it is not a bailout, but rather the entry of a new lending competitor that can win borrowers away from current mortgage lenders due to its long time horizon and low cost of funds. This is a major point because NOBODY wants a bailout if one can be avoided;
b) it does not require the creation of a new government bureaucracy (like the Homeowners Loan Corporation of the Great Depression) because existing agencies and workers can handle the minimal work involved, so fiscal responsibility types (who I admire) can support it without hypocrisy;
c) helping financial services firms by eliminating their root problem (defaulted mortgages) is much more popular than directly bailing out "Wall Street fat cats," which is especially important in an election year;
d) since any American with a mortgage automatically qualifies, this proposal does not directely discriminate against fiscally careful Americans nor does it unduly reward the fiscally profligate.

Of course most of those who will take the government mortgages will be subprime borrowers paying greater than 7%, those who got caught with teaser rates, ARMs, etc., and those about to be foreclosed upon.

This is a half hour's work, so I reserve the right to modify details if I have erred conceptually.

Finally, if done just right this is an example of a Pareto improving policy, a concept I urged politicians earlier this month to consider more carefully before going for the partisan jugular.

Your Humble and Obedient Servant ...


Anonymous said...

how much 7% debt are we talking here? ballpark. and how come no one smarter than me has commented. Or dumber than me for that matter.

Robert E. Wright said...

Good questions. As far as the lack of comments, Congress has apparently agreed to the substance of the administration's plan so there is little point ... I also received several e-mails, which I'll respond to in this post.

Central planning mentality types, like most people in government, think in terms of "how much?" and then try to divine an answer. My plan would have left the amount up to individual homeowners and their lenders. Since the government would have profited from the plan the amount was immaterial. Clearly, most Americans are paying their mortgages and would not want to swap out for a 7% government one because they have easier terms already.

Here are some privately emailed comments (C) and my responses (R):

C) 7% is way too high.
R) The figure is meant to ensure that only distressed homeowners take a government mortgage.

C) You can get a 6% mortgage almost anywhere.
R) Not right now you can't unless you have great credit and 10 to 20% down. If anyone could refi into a 6% mortgage we wouldn't be in this mess.

C) You'd certainly have the moral hazard problem that you'd get only the stinkiest stuff.
R) I believe that is technically called adverse selection ... but your point is well taken as that is PRECISELY the point, to draw off all the bad loans.

C) There'd be an incentive for people to manufacture bad mortgages. We collude. You lend me a ton of money guaranteed by totally insufficient real estate. I refinance with the Fed, you get government bonds. I default. You and I split the proceeds. To guard against this, you'd need to inspect the property that is deeded against the mortgage and appraise it, etc.
R) Well, I guess I didn't explicitly state it but there would be a cutoff date. The plan is for existing mortgages only, not stuff written going forward. The IRS can tell who has an existing mortgage because the homeowner almost certainly received an interest deduction.

C) Why not simply let the financial markets panic and flop? The depression should be over by 2012 or so, and the financial markets would learn a lesson that they'd remember for a generation.
R) Excellent point. Contrary to myth, World War II did NOT get us "out of the Depression." The economy bottomed in 1933 and began growing again in 1934. It had largely clawed its way back to 1929 levels by 1937 when some ill-advised government policies sent it into recession again. Of course that points to another risk, that the government would extend the depression with ill advised policies down the road. So we could be looking at more like 2016 or 2020. That's a long time to be depressed economically, especially since our enemies would certainly take advantage of the situation.

Anonymous said...

A question: Does the Bailout Plan call for the government purchase of individual mortgages (i.e., one property, one mortgage) or chunks of mortages via CMO's, etc. Seems to me your plan would be exceedinly costly and time-consuming to implement


Robert E. Wright said...

#1 -- it is a rescue plan, not a bailout plan.
#2 -- it calls for buying individual mortgages
#3 -- its effect on the markets would be virtually instantaneous because it would remove all uncertainty about the value of CDOs &c. because either
a) borrowers will continue to pay on their current mortgages OR
b) they refi with the government at 7% OR
c) they default and the lender immediately refi's with the government at 7%
The markets can then immediately price the various MBSs.

As far as the cost goes, the government already collects most of the information it needs. The IRS knows if you have a mortgage or not, and how much interest you pay. It also knows your income, number of dependents, etc. Now, I am a bit of a libertarian so I don't want to assume that the government will implement the plan cheaply but that is a fight we can have another time ...