The Magazine

Building a Better Bailout

It's time to reward virtue.

Dec 1, 2008, Vol. 14, No. 11 • By LAWRENCE B. LINDSEY
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The new mortgage would have one very significant difference: It would be a full recourse loan. That is, if the borrower fell behind in the payments, the government could use any means necessary to get repaid. That means not only foreclosing on the house (as under current mortgages) but also collecting any remaining unpaid sums after the house was foreclosed on by garnishing the wages, bank accounts, and other assets of the borrower. Think of it as the IRS providing the loan on the same collection terms as it does on taxes, or perhaps using the powers the government now has to collect on student loans.

The homeowner would not have to get a credit check, or have the house appraised, or go through the titling process again. There would be no debt-to-income or loan-to-value thresholds to qualify for the new loan. Refinancing on the new terms would be entirely at the discretion of the borrower.

Homeowners would have to think very carefully about taking the new loan. If they went for the lower rate, the obligation to repay would become very real. Individuals whose homes had market values way below the amount of the mortgage would have to be particularly careful. If they planned to live there for many years, there would be no problem. If they did not plan to live there or bought houses as a speculation, they definitely should not take the new financing terms. If they sell the house for less than the mortgage, they would have to come up with the difference from other sources.

Homeowners facing some economic distress but who otherwise would like to stay in their homes, even though the price was below the mortgage, might still find it attractive to take the new financing deal. For example, anyone with a 6 percent mortgage would see a 200 basis point drop in the cost of carrying a home. On a $200,000 mortgage, that would be a saving in principal and interest of $244 per month. (The monthly income of that homeowner is usually in the $3,000 to $4,000 range, so this is a significant saving.) In addition, the monthly payment would likely go down even more on loans that have been in place several years since the principal repayment period would once again become 30 years. If the homeowner is about to face a balloon repayment on a home equity line or an interest-rate readjustment under a variable rate mortgage, the new mortgage terms might make the difference between being able to stay in the home and facing foreclosure.

The key is that homeowners would have to make the choice. Only the homeowner knows whether he or she will be likely to stay in the house and repay the mortgage or be forced to give it up. Under the current arrangements, the homeowner has no incentive or need to signal his or her intentions. Instead, computer-driven models make a probabilistic estimate of how many home-owners in a given mortgage pool will choose foreclosure and what the loss rate will be on the foreclosed house. All of this then gets built into the price of a given mortgage-backed financial asset. Given the risk-averse nature of current markets and the lack of any real information, it is likely that the market price of the mortgage pool is well below the actual likely outcome. But no one knows for sure. As a consequence, Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) are clogging up the financial system.

Under the refinancing option, this problem goes away. The world is divided into two sets of homeowners: those who think they will repay and those who don't. Those who think they will repay take the new government mortgage. The old mortgage is repaid. All of the MBS and CDOs in the system therefore face immediate full-dollar repayment of all the "good" loans in the mortgage pool. Everything that is left can pretty much be written down to pennies on the dollar. The uncertainty regarding securities pricing is gone. Banks and the financial markets know with a good deal of precision what each security is worth. In fact, they are handed a series of checks for the bulk of the true value of the security as the wave of refinancing works its way through the system. Thus, not only is the uncertainty removed, but the entire financial system is liquefied.

This in turn will unfreeze the banking system. There is right now no market for the CDOs, and they remain on the bank's books. This consumes capital. Because of the distress in the market, the value of the CDOs keeps falling, and, as banks must report the value of assets over time, the banks must take a loss. This loss lowers the amount of capital the bank has. Less capital means that banks must shrink the size of their portfolio. But, the bad stuff can't be sold. So instead banks must shed good investments, and they are now doing so with a vengeance by refusing to make new loans and resisting the rolling over of existing loans. This starves the economy of credit.