Mar

9

These days all one hears is hundreds of billions here, trillions of dollars there. It almost seems like the B and T keys must be getting worn out. At the very least any politician who doesn't think in terms of billions is clearly not a visionary. Since we do counting here perhaps a little back of the envelope counting is in order. Suppose the government were to guarantee every sub prime mortgage out there. What would happen and how much would it cost? Clearly every sub prime mortgage would dramatically rise in value perhaps even higher than the value when they were issued. Their value on the bank balance sheets would rise dramatically. In many cases 3 fold to as much as 10 fold. Suddenly the banks would be wonderfully solid and flush with money. This massive infusion of capital into all the banks would come without a dime of Federal capital injection.

Just because the government guarantees a loan does not mean that the homeowners would or could keep making all his payments. Some will certainly default. Suppose also that the Government took over all such homes and kept them off the market for the duration of the current unpleasantness. Real estate would turn around much faster without the burden of more new homes being sold in foreclosure. Foreclosures would actually decline because a rising real estate market would give homeowners more skin in the game. But what would the cost be? There are 109 million full time homes in the US with $8T in mortgage outstanding. Supposing that the average mortgage is about 6% then the average payment is about 0.5% per month. This amounts to $40B per month. But in the 4th quarter Bloomberg reports that 0.83% of all mortgages defaulted. So the government would only have to $332M in new monthly payments every quarter. It is somewhat embarrassing to write a number as small as millions these days. Millions are so Twentieth Century! But the reality is we could save real estate, the mortgage market and banks by just making relatively small payments over the next few months.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Stefan Jovanovich comments:

Our Dr. Phil's definition of "the banks" is interesting. It includes (1) the borrowers and implicitly (2) the counter-parties to Citi and the other Tennessee Williams banks' outstanding swaps, asset-backed paper and other promises and (3) the bond-holders for these wonders of financial construction. The one group that has been left out of the discussion so far have been those terrible villains of the present economy - the people who insist on saving instead of borrowing and spending money - aka (4) the depositors.

The FDIC has made a belated move to acknowledge that their reserve fund and the contributions of the healthy country banks will not be enough to save the money center bank depositors. As recently as November they were still pretending that everything was OK; now they are realizing they better get in line at the Treasury window if they expect to be able to avoid a bank run. The current increased guarantees for the people who put money into the banks expire at year end. The Treasury barely has enough credit left to make good on its indirect promise to the depositors. If, as Dr. Phil suggests, the "banks" and their mortgagees are going to be allowed to have priority, everyone who can will swap their checking account balances for T-bills and cash. (No doubt Paul Krugman will then decide that it is declining velocity that is the problem.) Having already seen the rerun of 1930, we will see 1933 all over again.

The "crisis" is one that businesses face every day but that most academics literally have trouble understanding (it must be that they can endlessly recycle those same old lecture notes) - namely, the market had changed and a lot of inventory has gone bad. You can changing the price tags on the shelf all you want; no one is going to buy them for cash.

George Parkanyi writes:

I agree with Dr. McDonnell. Western governments should guarantee MOST of the paper (not the worst of the pure sub-prime stuff that's basically uncollectable - something needs to be written down) - at maturity, and not buy it outright now. In fact I would make the interest tax-free in the US, and get the Europeans to do the same in Europe. Make them government muni-bond equivalents.

I would even re-securitize them (make them collateral) for essentially new standardized government Treasury mortgage and asset-backed securities - that would then be traded openly on exchanges - with associated derivates like futures and options created (think the T-Bond or T-Note markets) so the owners can risk-manage them. Banks and financials could then move them off their books over to investors, who would have collateralized government securities - ironically now more safe than unsecured Treasuries.

For all the billions being thrown at the problem, surely a billion or two out of that could buy a lot of accounting and book-keeping horse-power to document, track, and value the "collateral" - the income streams from the mortgage and loan payments, and the value of any re-possessed assets. Create a single clearing house for all these securities that come into the program, managed with a war-time urgency as a matter of national security. The current income, and recoveries from property sales, would fund the first waves of re-payments as they come due. This would serve to defer the un-secured at-risk portion of the total package well out into the future, buying time to resolve all this leverage in a more orderly fashion.

Then move toward solving the structural problems. Still allow financial engineering, securitized products and derivatives, but never again unregulated, off-exchange, or off-balance sheet.

Legacy Daily replies:

I just cannot figure out how the numbers work.

According to this, mortgage debt outstanding is about 15T.

Based on this article around 11% are delinquent.

If government guarantees 1.65T, at 6% average that's 8B per month? Ignoring moral hazard (since already ignored anyway), we still have the issue of 11% increasing as a result of unemployment.

Giving a government ability to hold real estate at a large scale is only a leap or two away from certain factions pushing to "increase" the living standards of the proletariat (similar to what created the sub-prime fiasco in the first place) at the expense of others. With all its issues, the current system of private real estate ownership is a key factor in protecting freedoms. I am sorry but I see many negative "unintended consequences" in the proposals mentioned.


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