A Better Bailout

Overview

As details of the administration’s proposed bailout emerged, argument has flared up around the net regarding the merits and costs of the program. While there are many criticisms, there are few solutions. Clearly the government should intervene in some fashion to help stabilize financial markets before the markets sink the rest of the economy into a depression, the devil is in the details. I would like to propose a better bailout, both fairer and more powerful than the current Blank Check Bailout on offer:

At this stage of the game, in order to halt and reverse the course of the crisis a multi-pronged approach is required to address different aspects of the crisis simultaneously and begin pushing market expectations back up. The way to do this is to first prevent as many future losses as possible, mitigate existing losses as much as possible via recovery efforts, and finally, an injection of confidence and optimism into economic forecasts of market participants.

First, the government needs to address some of the issues that led us to this point, otherwise future confidence will be difficult to rebuild. Specifically, the government entity in charge of the bailout, whether it be called TARP or RTC 2, needs to work to prevent and mitigate losses on real estate loan pools that underlie the CDOs and MBS/ABS securities banks are holding. It can do this first by breaking the securities and taking out the mortgage loans inside of them. It can then improve their status via three main options: loan modifications, loan assumptions, and cooperative liquidation. In order to encourage banks to participate, the government could declare a temporary moratorium on foreclosures done outside of the government entity by commercial entities to basically force the financials to use the entity. Funneling all recovery efforts through a single entity creates huge potential advantages through economies of scale (mainly, reduced financing and administration expenses, since the government has access to far cheaper capital at this point) and a focus on a cooperative instead of a competitive approach to asset liquidation.

Wherever possible, existing loans that are in default should be modified if a reliable source of income can be documented by the borrower. However, instead of simply writing off a chunk of the mortgage balance, the loan should be broken into two parts: the main part, comprising at least 50% of the loan balance, should be redone as a fully amortized 30 year loan at the going prime mortgage rate.

The second portion should be a deferred loan that enters repayment in 10 years and has a 20 year term, also at the going prime rate. The exact percentages should be determined based upon actual, verifiable income, with the extremes being that if a borrower can afford his payments, he simply gets his loan refinanced into a standard 30 year fixed off the full balance; if he can afford only a portion of his debt but can handle the payment on at least 50% of the balance, then the calculation can be performed to charge what he can pay and whatever debt load he cannot handle immediately be set to deferral similar to a student loan. What this does is effectively push the problem portion of the balance (still liened against the property) out into the future when the borrower will both earn more (due to inflation if nothing else) and have a greater degree of equity in the home enabling a sale/refinance at a more opportune time.

In the event a borrower cannot afford the payment on at least 50% of the balance, if the borrower is willing to work with the government entity, the government entity should collect whatever can be justified based upon income as rent and post the property for sale – offering 100% financing PENDING rigorous standards of income verification. The main goal here is to replace a non-performing loan with a performing loan by finding someone who can afford the payment and effecting a transfer of ownership to that individual/entity.

Finally, in the event a borrower is uncooperative and/or unable/unwilling to pay his bill, the government entity would then be in charge of foreclosing and selling off the property. It should be noted that funneling ALL foreclosures through a single entity allows for a cooperative approach instead of a competitive approach to selling in an oversold market. That is to say, instead of having multiple sellers competing and cutting each others throats on price, the government can set depreciation levels, based on housing inventory in a geographic area, and effectively set a floor under which distressed sales will not burden the market. This has a beneficial spiral effect in restoring confidence to investors and lenders financing new projects/assets in an area as it sets a floor under housing prices. An analogy is to compare the current situation to multiple adults trying to exit through a standard 36” doorway – it is a virtually impossible feat to have multiple adults fit through the doorway at the same time, however if each exits in single file, then the doorway can process the exit of all individuals much quicker than if all try to cram through the door at once.

The next stage after Loss Prevention is Loss recovery. During the course of the Housing Bubble that lasted from 2002-2006, a large number of individuals across the spectrum of financial services firms made an extraordinary sum of money. Exit pay packages for top executives, such Stanley O’neal, former CEO of Merrill Lynch, Angelo Mozilo, former CEO of Countrywide Home Loans, Jimmy Cayne, former CEO of Bear Stearns, et al add up to a fairly large sum in the billions of dollars. This does not even include the upper ranks of the Investment Banking and Fixed Income teams that originated the securities or the fees charged by the mortgage pool originators. It is unreasonable that these individuals made such extreme levels of pay for creating and packaging products that performed so poorly.

Most of the pay packages were tied to performance, which as it turned out, was improperly accounted for due to inaccurate/false labeling of risks (e.g., counting them as Tier 1 instead of Tier 3 assets, etc.). As a result, that pay should come back and be used to help offset the losses so that the high returns from those time period help to offset the losses appropriately. While much has likely been spent, some recovery could be accomplished and it also would help rebuild confidence. The government also has the power to enforce repayment over a much longer time frame and through more arduous circumstances than a typical creditor.

Next the government needs to inject a great deal more scrutiny and regulation at a variety of levels in order to help rebuild confidence. Specifically, the banks, brokers, and mortgage companies need a single regulator. The current patchwork of regulators, spanning state and federal agencies, does not work due to entities engaging in regulatory competition, looking for the weakest regulator available. A single regulator with the ability to oversee the debt markets would be better equipped to spot and act upon poor practices forming in the industry. It would also be able to set licensing requirements not only for the firms, but also at the individual level. A uniform standard for everyone involved in originating debt with an examination to ensure competency, ethics, and material understanding (e.g., the equivalent of a Series 7 for the mortgage and loan industry, a Series M if you will). States could still regulate harsher standards on top of the federal standard, but it would set a federal floor.

In addition, a single regulator would be able to monitor compensation practices regarding securitized debt. Specifically, the hazards enjoined by paying originators and brokers upfront instead of over time were a big part of what brought us to this point, as the financials model were built upon selling off the loan pools and their derivatives before the loans adjusted or had a chance to default. A critical regulation would be to ensure trails instead of lump sum compensation; such practices are already common in retail brokerage operations and can be easily modified to fit the lending industry. Compensation practices are a major component of restoring confidence to the system as a trail system of pay is the only way to ensure originator maintain an interest in post issuance performance.

It should be noted that the government entity is likely to lose money in the end, RTC not withstanding. Despite all of the pressure and the technically superior platform advantages gained by access to government financing rates, it is likely banks will try to sell their most toxic assets to the entity. It is important to understand that institutions are run and operated by individuals, and no matter how noble any institution, an individual can turn it sour by being excessively greedy. It was not so much institutions that caused this mess as it was people. It would be grossly unfair to send the bill for the crimes of the few to the mailboxes of the many.

My solution on this aspect of the issue is to therefore use the finances of the many – the government – purely as a vehicle to finance and ultimately pass on the costs of the bailout, right back to the very people who created the mess. I therefore propose, that the government take the total LOSSES (not the amount financed, the amount lost, including any losses incurred from interest charges) and finance those losses by creating a special tax. The tax should only be levied on two groups of people: those who benefited form the real estate boom of the time, and those who work in those industries going forward.

So basically, take whatever the loss is, finance it with 30 year bonds backed by the Treasury (so it gets the 30-yr Treasury rate), calculate the payment needed to cover principal and interest each year and turn that figure into a % tax off the GROSS earnings of all those who worked in the industry at the time (mortgages, banks, brokers, real estate, construction) and those working in the industry for that year (same lines). So for example, if the loss ends up being $250 billion (actual losses not just amount financed), that would require $18 billion/yr on a 30 year note at 6%. $18 billion may sound like a lot, but if you took the combined earnings power of everyone in the financial services industry, real estate and construction industries, it would amount to a manageable sum that would hopefully be under 2-3% of gross income.

It is interesting that aside from providing a bit of justice to the rest of America for the bailout, that this also acts as a design block on the government entity being fleeced by banks and brokers dumping toxic assets on the entity – since it will be those same individuals who end up paying the special taxes. By making it an employment tax instead of an institutionally focused tax, it also helps preserve competitiveness of the institutions since the firms get to simply dump the tax on their employees, allowing the firms to continue operating (necessary for saving the system) while punishing the people who made the mistakes. Note that for the gross tax to work, it would have to be assessed yearly on all gross compensation, including the increase in value of equity, stock options, and the monetary value of any fringe benefits such as paid for items, homes, cars, etc. You would likely also have to pass a law prohibiting firms from paying the tax on behalf of their employees, else executives would likely abusive it judging from the past few years.

Finally, the government could take some technical steps to help restore confidence in the forecast for the broader economy. First, the Federal Reserve could announce a position of reducing the Fed Funds rate, but not by quarter and half point increments. Instead, it should announce a mild bias towards risks to growth and lower rates by 10 bps and indicate that it is likely to continue doing so for a few meetings. One of the greatest mistakes in this crisis has been the Federal Reserve’s usage of the Fed Funds rate; it cut massive amounts in late 2007 and early 2008, causing rates to plummet for short periods of time – and then rebound. By setting the expectation that for a year or two rates will be decreasing, albeit ever so slowly, it gives incentive for individuals to loan at current rates. The small amount reduces inflationary impact as well as stretches out the Fed’s remaining position on the Fed Funds Rate (currently they only have 2% left to work with).

Second, while the Fed is slowly slicing off the Fed Funds Rate, the Treasury Department could sell 300,000 barrels of oil per day into the markets from the Strategic Petroleum Reserve (simultaneous to the Fed Funds rate cuts) for the next 24 months. The current supply/demand balance is very tight and even a small quantity such as 300k/day could tip the balance in favor of lower oil prices.

While this policy is the least sustainable, it would have the effect of cooling inflation while the Fed was cutting rates as oil is the primary cost in transportation, and transportation gets factored into virtually all aspects of the economy at this point in time. It would burn off 100-200 million barrels of oil from the 700 million barrel strategic oil supply, but if the systemic risks are truly so great that the government is willing to consider a $700 billion bailout, then its worth using the SPR as a chess piece. As is, oil is trading at quite a nice premium to its 5 year average and the government would likely pocket a profit on the sale.

Third, the government should re-legislate the uptick rule back into the equity markets as well as pass additional penalties for naked shorting. This will help ensure short sellers do not artificially assist in pushing companies into bankruptcy by denying them equity raising options.

Finally, the government should pass some form of law ensuring the Federal Government is ahead of any and all creditors, a law guaranteeing the primacy of federal debt would help as it would enable the government to loan money to these institutions without worrying as much about existing liabilities being senior to the federal debt.

The overall goal of all of these measures, from the government entity to the technical measures, is to liquidate existing problem assets under the most favorable conditions possible with the underlying financing being as cheap as possible courtesy of the Treasury’s ability to borrow at low rates and restore confidence going forward, both in the economy at large and in the financial system in particular. This is accomplished by setting up multiple positive vectors that continuously push the market into a favorable forecast and keep it moving in that direction – not by one time interventions where the government cuts rates in half in one day, outright bans short selling, or bails out company after company.

If we can help the financial firms in our country resolve the situation through cooperative approaches (non-competitive asset selling mixed with cheap government financing) and help them shore up their balance sheets while simultaneously improving the outlook going forward, this credit crisis will melt away and the economy can continue its upward march. What is needed is a nice system of built in checks and balances outside of $700 billion blank check proposals.

Disclosure: None

Comments

[John Lounsbury:]

Congratulations on trying to address the underlying problem of a collapsed mortgage paper pyramid. I haven't analyzed the details of your proposal but you are looking at what has to be sorted out before this crisis can end.

2008 Sep 26 10:18 AM

[Ray Westphal:]

You are saying what I have thought only you sound more professional. You have to forward this on to congress and get it on the table, ASAP!!! Thank you for your insight GREAT JOB!!!!

2008 Sep 26 12:40 PM

[mallarde:]

I do not like this proposal at all. rather than addressing The liquidity issue directly, it attempts to address it indirectly by helping the speculative home buyers. By propping up individual homebuyers, Mr. Arguello believes he would shore up the securities that their mortgages underlie.

this is questionable. Also, it would take time for this to play itself out. In the mean time the securities would still be illiquid -- there would be no market for them.

With regard to assisting speculative homebuyers, I have a moral issue with my money -- I should say more of my money since my tax money already subsidized their speculative investments -- assisting these irresponsible, shortsighted people.

And where does Mr. Arguello come up with the 50% figure? That is not a very high hurdle for a mortgage borrower. Is the taxpayer to pay for 50% of the speculative investors house?

What is too seldom stated publicly, the vast majority of people that are in trouble with their mortgages are not in trouble because they were laid off. This is why the present situation is different from the Great Depression. Today, people are in trouble because they never were capable of paying off the loans they entered into. They were irresponsible and entering into them, and I do not want to help them now. As a life long renter due to spiraling prices, bailing out speculators now would be very ironic on a personal level.

2008 Sep 26 01:14 PM

[CaptBob:]

Anyone that thinks this has to do with residential mortgages better start burying their head above the high tide line. Fanny and Foolie already have more than enough to buy them all back.

And don't believe --Only the biggest crooks are capable of borrowing $$ from the Fed. and making short term loans to business and industry. They want to go on Strike and choke the economy with NO Credit--OK--let em go down let the AG go over them and license a new smaller bunch to handle Fed money. If Benny balks, we'll know he's in the Cabal.

Where's it say if a big bettor has a bad day with the ponies Govt. insures his bets or he closes the track???

The part of this plan no-one's seen is the sheet music for the Fat Lady to sing.

2008 Sep 26 02:37 PM

[bobbobwhite:]

The problem with the above: State's rights will find a way to trump fed regs through some loophole or grandfathered statute and then we shall have each state ruling how it solves all these crises. No improvement at all from the present morass. Trying to put all the above stated improvements under one fed reg is like putting all the eggs in the country under one hen. That false sense of security breaks down as the other hens constantly work to find ways to steal whatever falls out or is not watched well. And, politicians are even worse than hens, we all know so very well.

2008 Sep 26 03:39 PM

[wcrxlp edit...:]

There are three thousand community banks that are capital starved or near capital starved.

When Wall Street absorbs the $700 billion, Main Street banks will pay dearly to maintain their capital ratios.

It makes more sense to distribute the $700 billion to American community banks so they can lend for local transactions or use it to recapitalize Wall Street.

2008 Sep 26 04:03 PM

[bynd2009:]

very well written and should definitely be forwarded to Prof. Paulson for his serious consideration. Implementation might be problematic because the State regulatory agencies dislike Feds telling them how to take care of business (just look at the nuclear power issues) and will definitely tinker with RTC2 or whatever it is named to weaken its powers. I love the idea of taxing all the morons who gloated about the millions (some took 100s of millions) they took home by creating and marketing these CDOs, SIVs, MBSs and all the other alphabetical soups of illiquid opaque asset baskets. May be one of the presidential candidates should take this up !!

2008 Sep 26 07:01 PM

[muley101:]

Plan B: The Mortgage Investment Bill
for Reviving the Economy

by Stan Muse

The Federal Reserve is out of Federal Funds rate options and now the Congress is about to pass legislation which will be the largest bailout bill in the history of the world. Fannie Mae and Freddie Mac are now penny stocks with perhaps over 1000 bank failures yet to come. The American taxpayer will be told that they and their children will be writing big checks to rescue the Wall Street crooks and congressmen that caused all the problems, while receiving nothing in return.

Anyone who has been following recent congressional hearings knows by now that this is unacceptable to Main Street, the voters who will be firing their congressmen for turning the USA into a socialist country. It is also widely believed that this bailout bill may not be embraced by Wall Street because of its onerous terms even if passed. Finally, it will not provide sufficient liquidity for improving the rest of the economy.

A much more effective and fairer way to end our economic crisis is easily attainable. To state it simply, all Congress has to do is to pass a Mortgage Investment bill which allows individuals a one-time option to use some of the funds in their IRAs to pay off their mortgage balance in full, without any penalty, interest, or taxes for doing so. In return, individuals choosing to exercise this option give up their mortgage interest tax deduction for life. This bill could be passed quickly and independently of any other economy-related legislation currently being debated, or included in the current bill. Individuals choosing this option would need sufficient IRA funds to pay mortgage balance in full. The actual payment to the individual’s mortgage company would be done by the IRA managing institution to avoid fraud.

As one senator recently stated, ‘for most people their home is their IRA’. For many others, their 401-K plans hold many trillions of dollars, much of which by now is parked in money market funds or T-bills as mine is. If these IRA funds could be released to pay off mortgages, we could possibly avert, or at least significantly shorten, the economic recession we now find ourselves in. In fact, no other bailout legislation may even be necessary, although more regulatory legislation is certainly needed.

I asked Allan Meltzer, Arthur Segel, and Ellen Zentner to review this proposal and received some positive responses. Ellen said it seemed to be fool-proof and better than a reverse mortgage. In fact, it is a no-brainer for the homeowner with a large 401-K balance, and for the government. The only people who might object, as Ellen stated, are the bankers who want to keep homeowners dependant on them, especially those in the upper-income group. But even the bankers can not want the government to own a large stake in their business for a multitude of reasons.

It makes sense to allow people to use their IRA money, which they earned, to invest in the best and safest investment they could ever make, their home. Presumably they will need a place to live in retirement on a fixed income. It makes no sense for someone with more than enough IRA funds to cover their mortgage balance to loose their home because they lost their job and can not pay their mortgage. It also makes sense because it is not some form of government bailout which rewards the bad behavior of mortgage companies and unqualified borrowers. Instead, it rewards the good behavior of those who have saved and invested in the economy

If only 5 million people chose this option, for an average of only $200,000 each, the result would be $1 Trillion in paid-off mortgages, providing liquidity to the mortgage industry. By executing the option, an individual’s annual mortgage payment would become disposable income to put back into the economy or back into IRA accounts. To the individual, the effect is the same as lowering taxes. If only 5 Million people were able to put back $20,000 per year into the economy, the result would be a $100 Billion per year stimulus package for many years to come.

In my case, with $800K in IRAs and a secure pension, I would increase disposable income by $1600 per month while reducing the IRA balance by only $160K, but saving over $120K in future interest payments. I could retire, which I can not afford to now, and leave my six figure job to someone else. I could also quickly replenish the IRA money used to pay off my mortgage with the extra income.

Adding a further provision to delay receiving Social Security payments for a year in order to exercise the option would be a baby step towards privatization of Social Security. Anyone financially able to exercise the option should be able to delay the payments. For every 5 million people choosing the option, approximately $100 Billion would remain in the Social Security fund. This could fix our problems with Social Security for good.

Some of the benefits of this plan would be to:

• Immediately increase an individual’s or married couple’s disposable income by tens of thousands of dollars each year while enabling them to become debt free, helping families to stay together
• Save homeowners hundreds of thousands of dollars in mortgage interest payments
• Encourage individual IRA savings by many who have never saved
• Allow many people to retire earlier than they otherwise could
• Create demand for housing, reducing inventory, and stopping the decline in home prices
• Stimulate the overall economy, creating and saving jobs
• Not cost the government anything, and actually Increase federal, state, and local tax revenues by eliminating individual mortgage interest tax deductions, without raising tax rates
• Force the banks to sell their good loan assets to cover their bad loan losses, instead of forcing the taxpayer to buy their worst loans, and increase liquidity for new loans to those who need them
• Allow the free market economy to work through the crisis rather than resorting to socialism
• Not increase the national debt nor the money supply as a bailout would do and contribute to inflation
• Allow the individual home owner to the freedom to become their own banker with the money they earn, reducing America’s dependence on bankers, and changing America from renters and borrowers to homeowners and savers


The merits of this simple plan, the Mortgage Investment bill, for saving the economy, instead of trillions of dollars for a Wall Street bailout which will socialize the finance industry, are obvious and would benefit everyone involved. The individual gets more disposable income and a chance to live debt free, the capital markets get needed liquidity, the government collects more taxes and collects them sooner at the expense of the bankers, the housing market gets more demand, and the general economy gets a much needed boost for the next few years.

Democrats should like this plan because they can claim that it lets the wealthy pay for this mess. Republicans should like it because it increases disposable income, which has the same effect the same lowering taxes. The average voter should like it because it addresses all segments of the economy with a huge economic stimulus package, not just Wall Street, and costs nothing while helping to pay off the national debt and potentially fixing Social Security.

2008 Oct 01 10:42 PM

[Diegojames:]

This is a great article. It is amazing that Financial Times, WSJ and these articles all know what to do that will not cost a trillion dollars.
But Pelosi,B. Franks, Dodd, Reid, et al have never read nor asked for hearings and then asked for a BLUE RIBBON PANEL to deliberate the way out.....the FATAL CONCEIT being practiced by the DEMOCRATS is harmful for the USA ECONOMY.
That said....BUY BUY BUY...I am going long on COAL(BTU,ACI), CNG(CHK,XTO), JPM,WFC,GMO,DNN AND MORE LATER.....
THE economy will surge in needs for power for the winter then slowly in 9 months we will need steel.
Also nuclear deal with India is a time to go LONG on MDR for the nuclear facilities they need.
Diegojames
Northridge, California

2008 Oct 03 12:44 AM