BUB Seven

From CNBC (via the NRO Web Briefing):

The Flood of Foreclosures Shows No Sign of Ebbing

From my post about Obama’s Homeowner Affordability and Stability Plan:

If you want a plan to help individuals because you feel bad for those who are losing their homes, this is fine. If you want a plan that will help stabilize the economy then this is - I’m sorry - just plain stupid.

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All Bottom-Up Bailout posts are filed under the category “BUB”.

BUB Six

Obama has announced his Homeowner Affordability and Stability Plan (HASP). It’s oddly difficult to get a sense of what the whole plan is about although supposedly all will be revealed on March 4. You can read the official information here and Bloomberg has a Q&A. But let’s start with a USA Today editorial which identifies three main elements in HASP:

1) Current rules make it difficult for homeowners to refinance when the amount of their mortgage is more than 80% of the current value of their home. HASP “will make it easier for certain homeowners to refinance to lower rates if their mortgages are 80%-105% of the value of their homes.”

2) For “certain homeowners facing foreclosure [t]he government and lenders will share the cost of bringing mortgage payments down to 31% of monthly income.”

3) Obama “would alter bankruptcy law to allow judges to modify troubled mortgages just the way they do virtually all other debts.” This portion of the plan requires legislation; that is, this is the only part of Obama’s plan that he cannot impose by fiat.

Let’s dispose of the third portion of the plan first. This won’t cost the taxpayers anything directly but it does seem to me that it will make mortgages more difficult to get since it puts lenders at a distinct disadvantage. This will make it harder for people to buy homes in the future and harder for the housing market to recover much less rebound.

Furthermore, most mortgages are:

de facto or de jure ‘no recourse’. This means that the debtor cannot be held personally liable for the mortgage even if, after a foreclosure, the bank receives only a fraction of the total mortgage outstanding from the sale of the house.

With a ‘no recourse’ mortgage, the debtor effectively receives a virtual put option to ‘sell’ to the mortgage-issuer the house at the amount of the loan still outstanding.

Obama’s proposed change to the bankruptcy laws will set up an asymmetry in which a lender can be forced by a judge to eat part of the homeowner’s loss while the homeowner will still be able to simply abandon the house whenever he chooses. To redress that imbalance, we could change the other side of the equation so that any mortgage that can be changed by a bankruptcy judge is always a recourse loan. However, this would probably just encourage generous judges to be even more generous.

This leads me to the third problem with this proposal: a homeowner’s result depends entirely on how kind a judge he gets. I realize this is the case with other aspects of bankruptcy but I suspect it won’t take long for stories to start appearing in which two virtually identical cases have vastly different outcomes because one case is heard before a sympathetic judge and the other before a tougher one.

In other words, I think the modified bankruptcy element of Obama’s plan is a bad idea. Now let’s consider the elements that cost taxpayers money directly. The first two elements have a price tag of $75 billion. As far as I can tell, this includes financial incentives for lenders to refinance (probably $1000 per loan up-front then monthly or annual payments for some period); government payments of interest as needed to bring monthly payments down from a refinanced rate of 38% to the desired rate of 31%; and flat payments to homeowners who refinance and remain current for some period of time. (There is also a provision - not mentioned by USA Today - to pump money into Fannie Mae and Freddie Mac. I’m not going to discuss that but according to National Review this has a price tag of either $200 billion or $400 billion. Like I said, it’s hard to figure out exactly what’s in Obama’s proposal.)

So how will the first two elements of Obama’s plan work? Let’s consider two couples who are recent homeowners. Look first at John and Mary. They were both working a year ago making identical salaries when they bought a house. They had saved up their pennies for a few years beforehand and made a 20% down payment. The monthly house payments accounted for 25% of their combined take-home pay. Miraculously, they live in an area where the value of their house has not declined and after making payments for a year the amount of their mortgage is now 79% of the house’s market price. John loses his job. The house payments now account for 50% of the couple’s take-home pay. Nonetheless, they have cut other expenses to the bone and are still current on their payments. They do not qualify for Obama’s help. Because their mortgage is less than 80% of their income they can probably refinance without government help but there’s no guarantee of that since their income is now greatly reduced.

Right next door live Sam and Jane. Through an eerie coincidence they, too, were both working a year ago making identical salaries when they bought a house. Since they hadn’t saved their pennies, they only made a 5% down payment on their house but since they made more than John and Mary their monthly house payments also accounted for 25% of their combined take-home pay. Like John and Mary’s house, Sam and Jane’s house has held its value and after making house payments for a year the amount of their mortgage is now 94% of the house’s market price. Sam loses his job. The house payments now account for 50% of Sam and Jane’s take-home pay. Like John and Mary, Sam and Jane have cut expenses to the bone and are still current on their payments. Unlike John and Mary, however, Sam and Jane do qualify for Obama’s help because the amount of their mortgage is more than 80% of the current value of their home. The government will encourage their lender to refinance their mortgage perhaps at a lower rate than John and Mary could obtain without government sweeteners.

Now let’s imagine that instead of cutting expenses to the bone and staying current, Sam and Jane stopped making their mortgage payments when Sam lost his job. They are now in danger of foreclosure. That means they qualify for even more government help. Not only will the government encourage their lender to refinance, it will take on part of the interest payments to get their mortgage payments down to only 31% of their income.

The probable result is that John and Mary, who arguably made the more financially responsible decisions - a larger down payment and staying current on their mortgage - will be forced to sell their home. Yes, they will get back their down payment but if they can even manage to buy another house it will have to be a cheaper one partly because their income has been reduced and partly because they may have to pay a higher interest rate than Sam and Jane. Sam and Jane on the other hand will see some of their indebtedness paid by the government, will be able to stay in their more expensive home, and will never have to repay the taxpayers - including John and Mary - for their help.

But isn’t this sort of what I was proposing with my Bottom-Up Bailout (BUB)? No. First - and most important - under BUB, homeowners who got any type of monetary help from the government had to repay that help when they sold their home. Homes, actually, because the debt remained until it was paid off regardless of how many homes the owners went through. Someone seems to have pulled the chain on this light bulb at least for a couple of people at The Corner. Stan Liebowitz says:

Yet the government asks nothing in return from those being helped, even though it wouldn’t lend money to business without asking for something in return. Yet it would be easy to design a plan that had any helped homeowner pay back the help they are receiving out of any future capital gains on future house sales.

His co-blogger, Victor Davis Hanson, offers what he calls “a modest proposal”:

If you want the government to come in to rescue your mortgage, either by subsidized lower interest or reduced debt or both, then any future profits (not entirely impossible) you make at the time of any future sale must be divided 50/50 with the government.

Well, duh. Or to be more polite: Frankly, this seems to me to have been such an obvious provision for Obama to include - as Hanson says, “It seems a way to placate criticism that 92% are bailing out the less responsible 8%” - that I am tempted to assume there is some specific reason for not including a pay-back provision. Perhaps the portrayal of the mortgage holders as “victims” would be undercut by such a provision. Or perhaps the assumption is that those being bailed out will be the same people who would not be able to own homes at all unless the government had pushed for them to do so. In that case, a pay-back provision might have been considered undesirable because their problems are the government’s fault in the first place or because the government continues to believe they need help without responsibility. Or perhaps this omission really is simple incompetence or political tone-deafness.

As for other differences between Obama’s plan and BUB, I can pretty much just copy and paste the reasons BUB was better than FDIC Chairwoman Sheila Bair’s earlier mortgage plan:

1) BUB cleans up all primary residence mortgages where the amount of the mortgage is more than 80% of the house’s current value with no top end limitation). HASP only cleans up mortgages where the amount of the mortgage is between 80% and 105% of the house’s current value so if your home has lost a lot of value you're toast. Unlike HASP, BUB also cleans up all primary residence mortgages where the homeowner’s payments are more than 25% of income. Under HASP, if you have a mortgage that's seriously underwater or your payments are eating you alive, you're only going to receive help if you stop making payments and flirt with foreclosure.

2) BUB reduces mortgages to no more than 25% of income not 31% as Obama proposes. BUB thus frees up more disposable income which will translate into more spending. (In the long run. In the short run I hope people are smart enough to dig themselves out of debt first.)

3) BUB promulgates fixed-rate mortgages. Because Obama’s plan allows interest rates to rise after some number of years, he is essentially calling for adjustable rate mortgages. (Isn’t that part of how we got into this mess?)

4) BUB reduces principal; this helps soften the landing for the housing bubble implosion. Obama does not reduce principal; this keeps housing prices jacked up too high. (Obama’s plan does avoid Bair’s error of encouraging 40-year mortgages.)

In other words, as I said about Bair’s plan:

If you want a plan to help individuals because you feel bad for those who are losing their homes, this is fine. If you want a plan that will help stabilize the economy then this is - I’m sorry - just plain stupid.

Let’s face it. If only 8% of the people who have mortgages have any need for help, if a “mere” $75 billion can clean up the housing meltdown, then how much of a crisis do we really have? Either we’ve been sold a bill of goods about the underlying cause of the economic crisis or Obama is putting a band-aid on a mortal wound or Obama is proposing just the first round in what will be a continuing series of homeowner bailouts. I suspect the last is closest to the truth. As Phil Kerpen points out, deja vu in the housing bailout arena has been the order of the day.

Another factor that favors BUB is that it spreads the pain to the lenders. BUB requires them to take a 25% hit on the principal pay-down; Obama pays them off for refinancing. If we don’t want to encourage bad behavior, it’s far wiser for lenders who were greedy or stupid to take their lumps as a reminder to behave better in the future.

Last but not least, there is another huge problem with Obama’s plan that was also a problem with Bair’s plan - although I did not address it in my earlier post. Unlike my BUB proposal, Obama is not advocating regulation to insure we do not get into this mess again. Obama is not proposing legislation to require 20% down payments or perhaps even higher down payments when home prices are skyrocketing. Not only does he not want to eliminate adjustable rate mortgages or teaser rates, his own plan is an ARM plan. He is not proposing banning credit default swaps nor is he proposing any new Glass-Steagall type legislation. He is not proposing any penalties for or regulation of the rating agencies which seem to have been wandering around aimlessly slapping “AAA” sticker on all the garbage tranches. In other words, he wants our money to clean up the mess but is not doing anything to prevent the same thing from happening down the road.

And don’t tell me we have to stop the bleeding first then worry about everything else. Obama is the man who says, “We cannot successfully address any of our problems without addressing all of them.” He claims to be able simultaneously:

to create three million jobs, to redesign the health care system, to save the auto industry, to revive the housing industry, to reinvent the energy sector, to revitalize the banks, to reform the schools — and to do it all while cutting the deficit in half

Surely someone able to juggle all those tasks should have been able to couple his mortgage bailout with the regulatory and procedural changes necessary to insure we don’t need another one. Obama asking for my money to patch the housing crisis without fixing the underlying problems is like a roofer who charges you for putting a bucket under the leak in your kitchen ceiling: it doesn’t fix anything permanently and you know he’ll hit you with another bill when he comes back in a little while to empty the bucket.

Finally, a few words about fairness. My BUB proposal is unfair in the sense that it favors homeowners over renters and in the sense that, yes, some homeowners who were not innocently caught up but were actively rapacious would benefit. (At least I, unlike Obama, am willing to be up front about that.) In BUB’s favor, though, I would argue that it is at least as aimed at stabilizing the economy as were the $700 billion TARP bill; the money for the auto companies; the stimulus bill; and a seemingly endless list of other bailouts. We were told - and are still being told - that giving our money to companies that were greedy or stupid or both isn’t really fair but everyone will benefit in the end when the economy stabilizes. And besides the government will get all this money back someday. I believe I can make the same arguments for my BUB proposal and far more realistically. The pay-back feature; the greater inclusiveness; the more drastic reduction of payments; the insistence on fixed rate mortgages; the attempt to soften the landing for house prices without keeping them jacked up to prolong the bubble: all these elements address the economic problem as a whole rather than just targeting a handful of homeowners. Obama can not claim the same for HASP.

Oddly enough, however, that conclusion does not lessen the anger I feel toward Rick Santelli and those who have organized Tea Parties in response to him. I’m not saying Santelli and the Partiers shouldn’t be mad; they should be furious and I am, too - at least when I’m not feeling ill. It’s just that what touched off their outcry was a proposal by the government to help people with their mortgages. Not TARP; not the bailouts of various financial institutions; not the bailout of GM and Chrysler; not the stimulus package. According to Santelli, Obama’s mortgage plan “is promoting bad behavior.” And this makes it different from the earlier handouts how?

If Santelli was arguing that HASP was badly constructed and a better mortgage bailout plan was needed, I would be less angry with him. Instead he’s arguing that people who can’t pay their mortgages are “losers” who have no chance to “prosper down the road”. Does Santelli believe that the huge financial holding companies that tied themselves to those bad mortgages and keep coming back time after time for yet another handout are going to magically prosper somewhere down his road? How about the auto companies that haven’t made profitable cars in years? And what definition of “prosper” could possibly apply to all the pork barrel projects crammed into the stimulus package? Is Santelli saying it’s okay to give hundred of billions (not millions, billions) of taxpayers’ money to these “losers” but giving any money at all to homeowners makes Jefferson and Franklin “roll over in their graves”? Does he really expect me to buy the argument that AIG can be greedy and stupid and heavily implicated in poisoning the entire economy and still get government money (and get government money and get government money) but John and Mary who tried to do the right thing and got caught in the tsunami don’t deserve help?

I understand the mortgage plan may have been the straw that broke the camel’s back and I understand that it feels a lot more personal to have the government give money to your neighbor than to your credit card company. I also understand, though, that it all looks pretty ugly from where I’m sitting. A handout is a handout whether it goes to big corporations or the guy down the street and, frankly, if you weren’t out marching in the streets when AIG or Citi or GM got their money I’m disinclined to applaud you for rushing out your door the instant someone suggests giving homeowners some of that money, too.

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All Bottom-Up Bailout posts are filed under the category “BUB”.

BUB Five

There’s chatter on the Sunday morning talk shows about help for homeowners with unwieldy mortgages and in particular a reference or two to FDIC Chairwoman Sheila Bair’s “aggressive” mortgage plan. As usual the chatter - and Bair’s plan - focus on helping people who are already in trouble with their mortgages. If you want a plan to help individuals because you feel bad for those who are losing their homes, this is fine. If you want a plan that will help stabilize the economy then this is - I’m sorry - just plain stupid.

Stop playing catch-up. We need to leap aboard the onrushing freight train and start slowing it down, not continue to go chasing after it rendering medical assistance to the people it runs over as it picks up speed. Heck, Austan Goolsbee himself was on George Stephanopoulos this morning talking about how we need to think big in getting out of the economic crisis in order to “startle the thing into submission.” So let’s not parcel out money in dribs and drabs as homeowners get into trouble; let’s clean up the whole real estate mess now.

We need a Bottom-Up Bailout (BUB) and we need it now. There are a number of differences between BUB and Bair’s plan; I believe almost all of them mean BUB is a better plan:

1) BUB cleans up all primary residence mortgages not just those already in trouble.

2) BUB reduces mortgages to no more than 25% of income not 31% as Bair proposes.

3) BUB assumes fixed-rate mortgages; Bair calls for adjustable rate mortgages. (Isn’t that part of how we got into this mess?)

4) BUB reduces principal; this helps soften the landing for the housing bubble implosion. Bair does not reduce principal; this keeps housing prices jacked up too high and will stick some mortgage holders with 40-year mortgages which I think is psychologically tough. Also I don’t see anything about what Bair will do if even extending the life of the mortgage and using adjustable rates isn’t enough to get mortgage payments down to 31% of income.

5) Under Bair’s plan the FDIC provides default protection. BUB does not but by reducing mortgage amounts to 80% of current market value lenders will be protected in the result of default by being able to sell the house for more than the amount of the mortgage.

6) Bair’s plan will “pay servicers who process mortgages $1,000 for each re-worked loan”. BUB has no such provision but it’s a good idea especially since BUB would be mandatory not optional. We just have to remember this is a fixed cost which the government has no hope of recouping under BUB - unlike the mortgage paydown itself.

Anglachel has proposed something similar and - as I say in my comment to her post - although I like my plan better I do like Anglachel’s restrictions on equity extraction once a mortgage holder has availed himself of this program and her restrictions on getting around the payback by transferring the house to the kids or turning it into revenue property.

The other thing I say in my comment’s to Anglachel’s post is (link added):

Third, if Wheelan and you and I have all managed to come up with pretty much the same straightforward plan - easy to understand, simple to implement - why the heck are the people in Washington having so much trouble figuring out something like this? This is not - if you’ll pardon the expression - rocket science.

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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.

BUB Four

Boy, Item 2 of this plan sounds famliar:

To be honest, I don't know the exact details of how this Wall Street "fire" ought to be fought. I suspect it should involve two simultaneous strategies:

1. A government fund to buy distressed derivatives, which would inject capital into the system and provide some mechanism for pricing these opaque securities. The first step toward recovery is making the securities liquid again, meaning that they can be bought and sold at a predictable price, even if it's a low price.

2. A government fund to buy mortgages in foreclosure, or at risk of foreclosure, from lenders at a discounted price. So if I've got a $200,000 mortgage and I can't make the payments anymore, the government would buy it from my lender for something like $180,000. The lender still gets a haircut, but probably ends up better off than taking on the administrative expense of foreclosure and then having to sell the house in a dismal market.

The government would then restructure my loan with terms that I could afford, such as stretching the payments over 40 years instead of 30, or perhaps even lowering the value of the outstanding loan.

As a homeowner, I, too, should have to pay a price for borrowing more than I could afford. The government should be entitled to any profits on the eventual sale of my home up to the amount of whatever break they've given me. So if the Treasury knocks my mortgage down from $200,000 to $160,000, and I'm eventually able to sell the house for a profit, I should send a check to Uncle Sam at closing for $40,000 -- plus interest.

That's the essence of a sensible plan: Restore stability to the housing market at realistic prices; and inject liquidity into Wall Street, again at realistic prices. Just to stop the fire from spreading.

I don’t know whether to feel gratified or terrified that an economist Greg Mankiw references came up with practically the same plan I did. Although I wasn’t going to take the whole profit at resale. And my government wouldn’t charge interest.

*****

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.

BUB Three

I’ve changed my mind about the Paulson bailout plan - and the Democrats’ permutation and the Republicans’ alternative - a half-dozen times in the last eleven days. Here’s where I stand now.

If we’re going to give money to people who made stupid decisions, I’d still rather give it directly to the homeowners with the bad mortgages than to the big firms with the bad mortgage-based assets. The only change I’d make to my original Bottom-Up Bailout proposal is that only primary residences will be eligible for the plan. If you put yourself in debt up to your neck to buy a vacation home or to flip houses hoping for a quick buck, you’re on your own.

Barring that, there are two alternatives to the Paulson Plan floating around that sound interesting to me. One is Mort Zuckerman’s
suggestion that the government invest in perpetual preferred shares in the companies that need bailing out. As I understand it, perpetual preferred shares have no voting rights but are first in line for dividends and take precedence over common shares in case of bankruptcy. What I don’t know about this plan is which companies the government would invest in: any companies that wanted in; only companies that are really troubled; or only companies that the government decided were sound enough to get back on their feet with a little help. If the investment was restricted to only certain companies there’s a lot of room for political maneuvering and preferential treatment. It’s worth noting, however, that that’s at least as big a problem with the Paulson Plan since no one seems to be willing to specify which assets will be bought from which companies at what prices.

Another interesting idea is what Peter Robinson at The Corner refers to as “Plan B”:

the use of the FDIC to backstop commercial banks, on which (as quite distinct from investment banks) our system of payments and credits actually depends. The broad outlines of such a plan—increasing the deposit insurance level while giving the FDIC additional discretion to help wobbly banks—are in very little dispute.

As with the Zuckerman Plan and the Paulson Plan, the “discretion” part of “additional discretion to help wobbly banks” means someone has to choose which institutions live, which die, and which get dismembered and sold off.

One final thing to keep in mind when considering the Paulson Plan. We’re now hearing more and more about how the $700 Billion is an investment or even a “loan” because once the government buys the mortgage-based assets, it will hold them until the real estate market stabilizes then sell them and recoup some or all of the original investment - perhaps even make a profit. As Mort Zuckerman pointed out on the McLaughlin group this past weekend, we don’t know when or where the real estate market will stabilize; no one knows what value - if any - these assets have now or will have in the future; and he expects the real estate market to drop by another 15 to 20 percent. (I cannot find a link to this.) Similarly, Jeffrey Miron says:

Further, the current credit freeze is likely due to Wall Street's hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

The costs of the bailout, moreover, are almost certainly being understated. The administration's claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.

If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.

This less than rosy view of how much of our $700 Billion we’d get back doesn’t necessarily mean we shouldn’t follow the Paulson Plan. It just means that if we do we should accept we may never see our money again. Think of it like money you invest in your ne’er-do-well brother-in-law’s combination video rental store and laundromat: it’s possible his success will finance your retirement but you shouldn’t stop socking money away in your 401(k).

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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.

BUB Two

I started thinking about one of the articles I cited under “Sources and additional reading” in my BUB post. The article was a TigerHawk post called “Did Enron beget AIG?” In my earlier post, I said this about that:

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.

I went back and reread the TigerHawk post and the WSJ article it linked to and the comments on the TigerHawk post (Charlottesvillain is particularly helpful). Then I reread neo-neocon on “Naked shorts and other wonders of the financial world” and the articles she links to.

I still stand by my original statement 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.” To use a simple (and probably simplistic) analogy, imagine I am going to make cupcakes for a bake sale. I purchase $10 worth of ingredients and produce 48 cupcakes. That makes the underlying value of each cupcake about 21 cents assuming my labor is not considered. I price the cupcakes at 50 cents each. A couple sell quickly but when the buyers try them they discover the cupcakes taste terrible. Word spreads and no one will buy my cupcakes. Finally someone offers me 5 cents a cupcake - his dogs love sweets and he figures they won’t be too picky. I can argue until I’m blue in the face that the underlying value of my cupcakes is 21 cents each but the fact remains that their market value is 5 cents. Period.

What is clearer from my reading is that the market price of mortgage-based assets is not tightly tied to the value of the real estate on which they’re based. Home prices declined 20% while the market price of some mortgage-based securities apparently declined nearly 100%. Given this my idea to save the financial system by having the government buy up mortgages themselves rather than the distressed mortgage-based assets may not make a bit of difference to the market price - or liquidity - of those assets. It simply won’t matter that the underpinnings of those assets is now secure - the assets themselves will still be undesirable.

Rather than being a reason to do away with requiring mark to market pricing isn’t this actually a reason to do away with products that are so far removed from reality? The WSJ describes them thus:

Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them.

If no one can understand how these products are priced perhaps we should consider not creating them and not selling them. Or if we believe its important to continue to do so then we need a way to segregate exposure to incomprehensible and unpriceable exotics from more mainstream investment and banking - especially if we are going to insist that mark to market valuation is not applicable to such airy-fairy investments.

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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.

BUB

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.