Sunday, September 21, 2008


So the Bush administration is proposing a $700 billion dollar bailout for financial institutions that have been “clogged up” by the fall in value of real estate and, therefore, of mortgage-based assets. Obviously the truly capitalist thing to do is nothing: let the market work its will, shake out the bad investments and those who bought them, and just hang on until everything settles down. It seems to have been decided somewhere by someone that that’s not an option: the results would be catastrophic.

Okay, but then why give money to big financial institutions? I’m a total economic dunce but if the bedrock problem with the financial system is mortgages it seems to me the best way to address the problem is to address mortgages. In other words, how about a Bottom-Up Bailout (BUB)?

Let’s start with my understanding of how this mess happened:

1) Ordinary People took out mortgages to buy homes. (I’m including home equity loans when I talk about mortgages.)

2) Those mortgages got “securitized” and sold just as if they were stocks. That is, Local Bank made 100 mortgages. It glommed those 100 mortgages together and sold an interest in that agglomeration to Bigger Bank just as if it was selling stocks. Bigger Bank glommed together many of these 100-mortgage agglomerations and sold that larger agglomeration to Still Bigger Bank and so on up the food chain to even bigger banks and investment banks and brokerages and hedge funds. That means that AIG, for example, ended up with an interest in home mortgages in Outer Podunk.

3) Things got even messier because of derivatives. It turns out that nobody actually understands them. This means no institution dealing in derivatives could really calculate how exposed it was to a particular counterparty or market or asset holder or even country. In other words, no institution dealing in derivatives really knew how much of its assets were somehow tied to AIG; knew how much of its assets were somehow tied to, say, homeowner mortgages in places where property values were dropping like a rock; knew how much of its assets were somehow tied to a particular Bigger Bank; or knew how much of its assets were somehow tied to the United States. Not knowing how exposed it was to a particular entity or situation means an institution didn’t know enough to stop buying more assets from the entity or situation.

4) There also may or may not have been some problem with short-selling, particularly with “naked shorts”. I’m not even going to pretend to understand that.

5) Remember that the home mortgages taken out by Ordinary People are still the basis for all the assets we’re talking about: the agglomerations of mortgages sold as if they were stocks; the incomprehensible derivatives; and whatever the heck the naked short-sellers were dealing in. One big thing has gone wrong with these mortgages: house prices have dropped. This means the collateral for the mortgage (the house) is worth less than what people owe on that collateral. So if people cannot repay the mortgages they took out then the Local Bank that gave them the mortgages can’t get back their money by seizing and selling the house.

For example, let’s say the 100 mortgages that Local Bank glommed together were for a million dollars each. This means that Local Bank sold an agglomeration worth one-hundred million to Bigger Bank. And it was worth one-hundred million in two senses: the amount loaned for those 100 houses was one-hundred million and if the homeowners all defaulted on their mortgages, Local Bank could take their homes and sell those homes for one-hundred million.

Now, however, let’s say house prices have gone down by 75%. That agglomeration is still worth one-hundred million in the sense that the amount loaned for those 100 houses was one-hundred million. However, if the homeowners all default on their mortgages, Local Bank could only get twenty-five million if it took their homes and sold them. So the underlying asset - the real thing - is no longer worth one-hundred million. As long as people keep paying their mortgages, this is not a problem.

6) Unfortunately, people are beginning to not pay their mortgages. There are multiple reasons for this:

a) Some people got mortgages they couldn’t afford. We can have a big fight over why this happened. Some people say it happened because the government forced lenders to give mortgages to people who couldn’t afford them in order to overcome perceived discrimination toward minorities and poor areas. Some people say lenders took the government’s expressed desire to see less discriminatory lending and used that as an excuse to talk and trick people into mortgages they couldn’t afford and to load up those mortgages with bad fees and wicked interest.

b) Some people got mortgages they could afford but then they lost their jobs and now they can’t afford them.

c) Some people got mortgages they could afford but then the value of their house dropped and now they’re stuck paying a million dollar mortgage on a house they couldn’t sell for more than a quarter of a million dollars. Some of these people are hanging in there, paying their mortgages; these people do not contribute to the current problem. However, some of these people are reneging on their mortgages and abandoning their houses which leaves the bank that holds their mortgages out the three-quarters of a million dollars. Also, some of these people would continue paying their mortgages if they could but they have to move for work or family reasons and they can’t continue to pay a million dollar mortgage when they only get a quarter million to sell the house and they have to buy a new house in their new home.

7) As financial institutions became aware that the original value of mortgage-based assets was disappearing - the value of the homes and the willingness of the homeowners to pay their mortgage were both vanishing - they became less willing to buy those assets. In market terms that translates to offering lower and lower prices for those assets. So a mortgage-based asset that Lehman bought at $100 couldn’t be sold at $100. Instead someone may have offered only $90 for it. It looks like - I’m very hazy on this - Lehman may have said no to $90 and held onto the asset as the price offered for it dropped and dropped and dropped. It’s also possible that the price drop happened quickly: last week Lehman bought the asset for $100, this week it’s only worth $25. Whatever the mechanism(s), financial institutions have found themselves holding a lot of mortgage-based assets for which they paid a lot more than anyone is now willing to offer them. And here’s where things get interesting.

Treasury Secretary Paulson keeps referring to these mortgage-based assets as “illiquid”. That implies they cannot be sold. However, Naked Capitalist insists that these assets can be sold but the institutions that hold them are unwilling to accept the low prices being offered by bottom-feeders. In other words, if Lehman bought a mortgage-based asset for $100 it is absolutely unwilling to let it go for $75 much less for $50. If this is true, it’s not that the assets are illiquid, it’s that the institutions that hold them are not willing to take the hit they would incur by selling them. In other words, these institutions are refusing to accept a market correction.

So long as institutions continue to hold mortgage-based assets they suffer financially. Once everyone realized the mortgage-based assets weren’t worth much, financial institutions couldn’t use them as collateral to get the short-term credit they rely on to keep their business going; that was like asking your local bank to give you a home-equity line on your house after it burned down. Furthermore, these institutions owned so many of these mortgage-based assets that they didn’t have enough inventory in other assets to get the credit they needed - bad assets had crowded out good. Finally, as a financial institution revalued these mortgage-based assets to anything like their market price the total worth of the institution was dropping. A company that was worth ten billion dollars when mortgage-based assets were worth $100 would be worth less and less as the value of the assets dropped. As that drop was reflected on the institution’s balance sheet the value of the stock would drop. That meant the stock was worth less as collateral to raise operating money and the institution suffered more.

Now the government is going to bail out the entire financial system by buying up mortgage-based assets. Some financial institutions (it’s not clear which ones) will be able to sell the bad assets to the government, use the money to buy good assets, and go back to merrily doing business again. It’s as if the homeowner posited above found someone who would buy his burned downed house. He can go out and buy a new house and leave the buyer with the ruined hulk

The idea is that the government will hold onto the bad assets and gradually sell them. The big questions are:

1) How much will the government pay for these assets?

2) How much will the government be able to sell them for?

It looks like Treasury is claiming it will buy the assets at fair market price. The problem is that if no one is willing to buy these assets - that is, they are truly illiquid - there is no fair market price. If someone is willing to buy these assets, why can’t the institutions that hold them sell to those buyers rather than sticking the taxpayers with the bill? I’m very much afraid that the analysis at Naked Capitalist which insists that there are bottom-feeders currently willing to buy; that the asset holders refuse to sell for what the bottom-feeders are offering; and that the government will offer whatever the sellers demand in order to get their hands on those assets looks like what will happen. As for how much the government will be able to sell them for, I can’t think of any reason the government will be able to sell them for more than the current holders would be able to. So the government will pay the price the asset holders demand then sell the assets to the bottom-feeders. The taxpayer will pay the difference while the asset holder and bottom-feeder both make out like bandits.

So here’s my question. If the Ordinary People with mortgages they can’t or won’t pay are the root of this problem, why not solve the problem by addressing their difficulties? Instead of buying the mortgage based assets, let’s have the government buy the mortgages or, rather, part of the mortgages. That’s a Bottom-Up Bailout (BUB).

My goal is to have every mortgage holder end up in a stable mortgage position. That means:

1) The mortgage on the house is for no more than 80% of the house’s current market value.

2) The amount paid on the mortgage each month is no more than some reasonable percent of the family income. I would set a top-end on that percent - perhaps 25% - but I think the percent has to vary by income level. Someone who is making very little money may simply not be able to afford to allocate 25% of the family income to housing.

Everyone who has a mortgage can apply to the new program. If the homeowners are in a stable mortgage position they don’t qualify. If not, the government will pay off their mortgage to whatever degree is necessary to get them into that position. Let’s take an example.

John Smith bought a $250,000 home a year ago. He makes $50,000 a year. He took out a $230,000 mortgage, putting only 8% down. He has made principal payments totaling $10,000 so he now owes $220,000. His home is now worth only $150,000. So:

1) The mortgage on the house is $220,000 but the house is worth only $150,000. The 80% of current market value rule means his mortgage should be no more than $120,000. The government will pay off $100,000 of his mortgage leaving him with a $120,000 mortgage.

2) If his monthly mortgage payment on the new $120,000 mortgage is more than a reasonable percent of his income, the government will pay off more of his mortgage to get his monthly payment down to the desired level.

Yes, some people who were stupid and some people who were greedy will get away with murder under BUB. However, there is some pain for homeowners:

1) If a homeowner would qualify for this deal and does not apply for it or does not take it and subsequently defaults on his mortgage, he cannot ever qualify for another mortgage.

2) If a homeowner takes this deal then when he sells his house he has to start paying the government back for the help. Specifically, the homeowner pays the government the amount the government paid off for him or half the profit on the house, whichever is less. This rule applies to sales of any subsequent houses until the homeowner has paid off the government’s help. The government does not charge interest.

3) If a homeowner takes this deal and defaults on his mortgage, current law prevails except that the government is considered a co-owner with the homeowner for the purposes of receiving proceeds from the sale of the house over and above what the mortgage holder receives. In other words, if the homeowner still owes $100,000 and defaults, the loaning bank seizes the house. If it is sold for $150,000, the homeowner and the government split the $50,000 that the bank doesn’t get.

There’s also some pain for the lending institutions. When the government pays off part of a homeowner’s mortgage, it doesn’t pay 100%. In the example above, I say the government will pay off $100,000 of John Smith’s mortgage. In fact, the government will pay Smith’s lender, say, $75,000. The lender forgives and eats the rest. That spreads the pain to the local lender and from there throughout the financial system without inflicting so much damage the system collapses.

And, of course, the government reforms lending practices in general. Minimum down payments and limits on how much can be borrowed based on income are back in favor. If the government wants to help poorer people own homes they can do the lending to those people themselves with the understanding that the loss rate will be high.

Furthermore, some type of restriction needs to be in effect to compensate for housing bubbles. Perhaps the minimum down payment should vary based on how fast housing prices are going up. In other words, banks should loan less than 80% in areas where housing prices are rising fast.

Last but not least the financial institutions' practices must be reformed. If no one understands derivatives maybe no one should be trading them. If trading in exotically packaged assets puts the whole financial system at risk maybe it’s time to re-segregate parts of the financial system, a new Glass-Steagall law. I don’t know enough about the subject to propose reasonable legislation but if the taxpayers are going to help clean up this mess then their representative - the government - needs to make sure the mess doesn’t happen again.

If the government is unable or unwilling to reform financial institution practices, then the government must make it explicitly crystal clear that those institutions are high-risk and without government backup. Anyone who does business with them does so at his own risk.


Sources and additional reading:

Naked Capitalism (via Greg Mankiw)

Newt Gingrich at The Corner on NRO

Andrew Stuttaford at The Corner on NRO - Contains links to a Washington Post article and a Brookings Institute write-up on the bailout

neo-neocon on Naked shorts and other wonders of the financial world

Did Enron beget AIG? - Thoughts on mark-to-market regulations; links to a Wall Street Journal article that claims that the fact the market wasn’t moving meant the value of mortgage-based assets was marked down more than was justified by the drop in value of the real estate at the bottom of the heap. Interesting but it is still the case that if no one wanted to buy a mortgage-based asset then that asset’s value was zero regardless of the value of the underlying real estate.

Is Paulson wrong? - This is a link to a brief essay by Luigi Zingales. I cannot read the pdf he links to. You can read what purports to be the full text here.

Analysis: Washington's Trillion Dollar Wall Street Bailout - James Pethokoukis at U.S. News thinks the bailout is the way to go

Bipartisan Support for Wall St. Rescue Plan Emerges

For some very left and very interesting writing, check out
Anglachel’s Journal.

If I were John McCain's trusted adviser ... - An August 17,2008, article by George F. Will in which contains a proposal that sounds awfully good to me:

No officer of any corporation receiving a federal subsidy, broadly defined, can be paid more than the highest federal civil servant ($124,010 for a GS-15).


Updated October 24, 2008, with links to my subsequent BUB posts

Since I keep adding BUB posts, I updated this on December 13, 2008, to put all BUB posts in their own category. That way they can easily be found without my having to keep updating all the existing ones each time I add a new one.


Anonymous said...

Nicely amalgamated Elise!

Would you be interested in taking the Treasury helm from Geithner? His most recent inspired stroke of crisis management is to rail out loud and before the Congress about tax breaks afforded those nasty old energy companies. That's gonna help us when the tax rate is repealed and the costs are passed along to... ? Do these people have a clue?

The question above is based upon my assumption that there is someone at the helm... but I'm probably wrong.


Elise said...

Thanks, bt, but I don't think I'm qualified to hold an Obama cabinet position: I've always been honest on my income tax returns.

It seems almost impossible that Geithner (and Obama) truly don't know any cost increases to companies are passed along to their customers so I suspect they're just hoping most of us don't realize it.