Bailout Options

Ok, take a minute to read this story. A lot has been made about irresponsible borrowers and "subprime" loans to people who were encouraged to lie about their income. And both of those things did happen, and did contribute to the crisis. But there are plenty more like poster DarkSyde's co-worker, who trusted people, mortgage brokers, lawyers and bankers, who were supposed to have the buyer's best interests in mind. People who they thought would be scrutinizing the details for them fairly, but who really just wanted to get someone to sign on the dotted line so they would have yet another loan to sell up stream to investment banks desperate for more securities to sell.

Which brings us back to the bailout. The big advantage of a top down bailout is the small number of players. If you are going to hand out money and gain oversight, it is easier to do it with a few hundred banks rather than a few million homeowners. BUT, there is no reason you couldn't structure this problem as a cram-down to change the borrowing terms in favor of homeowners.

Look, these securities are already worthless because no one expects people like DarkSyde's co-worker to keep making payments on his crazy loan, the logical thing for him and people like him to do is just move out and leave the keys at the bank. You owe more money than your house is worth, why are you paying down the loan? If he had a mortgage with a small local bank (that didn't sell his mortgage upstream) he could go down to the bank and renegotiate terms. The bank doesn't want his house. If he dropped the keys off, the bank would instantly lose money, PLUS they would have the time and expense of selling a house. A bank would much rather set up a situation where they take a significant loss spread over 25 years than a big up front loss today (for very sound mathematical reasons, see this on the time value of money). So why can't people like this go renegotiate their loans? It would be good for the banks, and it would be good for them!

Ah, but you need to understand the perverse incentives that have been created. You see, "Local Bank" that wrote you that loan didn't keep it. They sold it on to "Investment Bank" in exchange for a quick profit. Investment Bank then pooled that mortgage with hundreds or thousands of others like it, and tied the payments to special bonds, consolidated debt offerings or CDO's. These bonds were then sold to banks and other investors. So now Joe Shmoe's loan is owned not by one person, but LOTS of people. But it gets worse! Those people who bought these bonds often bought insurance. For a small percentage fee of their expected return, another company would insure them against default. The bond holders only collect on their insurance IF people default on their loans. In other words, they don't want to renegotiate your loan, because if you default, they get paid and the insurance company is left holding the bag.

And that works fine until everyone starts defaulting, and insurance companies start going out of business, so nobody gets paid.

An alternative solution would be forced cram-down. In other words, the government could force a renegotiation, or more likely a standard set of terms with lower interest rates over all mortgages. This would reduce (or in some cases eliminate) the profits to bond holders (because they were supposed to pay out higher rates of interest), but considering these assets are basically worthless now (because no one expects people to stay in houses that are under water) they would actually have value again. Losses around 10/20c on the dollar instead of 70-90 cents. Home owners would benefit because they would be able to stay in their homes and the reduction in mortgage defaults would probably slow the rate of decline in property values.

I don't know if this is the best solution. There's a lot of upside, but the problem is the transaction cost. How do you decide who qualifies? And if you set up criteria, you need to have a set of impartial people to verify these conditions. Dunno... but it sure sounds better than the US government buying billions of dollars of bonds that everyone in the private sector seems to think are worth about 10 cents on the dollar.