We are in ‘The Perfect Storm’. By that I mean we are dealing with an unprecedented confluence of systemic failures. Not to place blame, but to understand the dynamics of what has and is happening.
There are a number of issues, but to understand the dynamics, you need to understand the players. No matter what solutions are tried, all the players have to think they are getting the best deal possible, or they will hold back the solution.
- Player 1, The Sub-Prime mortgage holder
- Player 2 The Prime mortgage holder
- Player 3 The Banks holding both of the above
- Player 4 The Government
- Player 5 The Stock Market.
The exact mix of mortgages that managed to wend its way like a virus infecting our financial system is not really an issue any longer. The damage is done so how do we mitigate it.
Part one of this is that the situation for many, if not most of these mortgage holders had become even worse than when they bought/refinanced their home.
Part two is that the market value of the homes they bought is currently less than their loan balance. Due to banking rules of accounting, (Mark to Market) this causes a problem for the banks due to their exposure.
The Third part of this confluence is that the ramp up in interest rates was in part, a tipping point in this crisis. So what can we do?
The Bad Bank Idea:
This idea has been around for a long time, but I would propose a new internal paradigm. Many of the banks holding these ‘bad loans’ are concerned that under the current rules, they could become insolvent by just looking at the extent of the problem. To make it easier, and safer for them, I propose the following structure
- The Bad Bank (BB) will offer to buy mortgages at 50% of outstanding principal balance on the loan.
- The Offering Bank (OB) will maintain a 50% equity stake in the loan.
- The BB will immediately recast the loan as a 4% 30 year fixed loan to the mortgagee.
- The BB will hold the mortgage for a time agreed to by both the BB and the OB. Upon sale of the loan (or liquidation in the case of houses that still foreclose after the conversion) the BB will recover it’s original investment, and then split any balance with the OB.
- This will encourage private investment in the BB reducing the Government’s exposure, while offering a possible return for the government on what would have been a loss.
Why will this work? The reason this works is that it has a benefit for all of the players.
The Sub-Prime holder gets a second shot at keeping his house. Even if underwater at the moment, most homeowners would rather keep their home and hope to catch up while they live there then walk away and kill their credit, and any chance of getting another one in this century.
The Prime mortgage holder (a passive but very affected player, as home prices drop due to the expected 3 to6 million homes coming on the market through foreclose this year.) If we can prevent 50% of the expected foreclosures through the BB then that glut of homes will not appear, and home prices will stabilize. This will allow the Prime Mortgage market to get back to work.
The Banks holding mortgages get a good shake also. By selling at a fixed number, they can estimate their downside immediately, and have a potential upside on the 50% of the loan they wrote off. Those warrants can even be traded. Which the 5th Player, The Stock Market will love, since the only uncertainty is to the up side, while getting the rest of the financial market, comfortable enough to start opening up the throttle a bit.
And finally the Government feeds the BB, but allows private capital to eventually supplement and even replace the government stake with the possibility of some long term costs, but the possibility of long term profit..
An all around win, and no one gets off the hook completely unscathed, the pain is shared. No bail-out for the homeowners that bought in over their head, but at least says, “OK, prove you can, and we will help you.”