By David M. Abromowitz and Andrew Jakabovics
Unless U.S. Treasury Secretary Henry Paulson's first stab at a $700 billion rescue of the global financial system is revised to incorporate restructuring troubled mortgages, it will be neither fair nor effective. Paulson's draft legislation attempts to rescue the balance sheets of Wall Street but does almost nothing for homeowners on Main Street. That's a fundamental flaw. The U.S. housing market won't recover without restructuring of underlying mortgages that are troubled. Global credit markets will not respond to this exceedingly expensive plan unless we get our fundamentals right. Moreover, taxpayers will be saddled with increasingly worthless paper as many of the underlying mortgages fail.
The Paulson plan demonstrates a disturbing disconnect between the "mortgage-related assets" that taxpayers' $700 billion is being used to purchase and the necessary restructuring of the troubled mortgages themselves. Many hard-working Americans are having trouble paying on their mortgages, which in turn is driving down the value of their neighbors' homes across the country. Tens of millions of families have seen their home values plunge through no fault of their own. Nearly 1 in 10 American households--roughly 5 million--have a mortgage that is either in default or facing foreclosure. These are the families still struggling to pay their mortgage even after the earliest subprime borrowers have already lost their homes.
Without provisions expressly aimed at helping these borrowers restructure their mortgages with federal government assistance, this grand plan to buy "toxic" assets from the financial institutions that engineered this market meltdown will not help the U.S. housing market recover. The Bush administration, however, is clearly only interested in trying to provide immediate relief to financial institutions.
Under Paulson's draft plan the Treasury secretary will have the cash and the power to buy troubled assets, and help financial companies cleanse their balance sheets. But it is not at all clear at what price, or through what mechanism, these purchases will be made. These are critical details if the plan is to work even by its own terms. Congress is raising legitimate concerns about not creating windfall opportunities for investment banks, securitizers, lenders, and investors to sell their distressed debt to Treasury at above-market prices. To address those concerns, Treasury should set a maximum price to be paid, then conduct a transparent auction to determine a real market value for the assets.
But even if the Treasury Department can buy up mortgage-backed pools of bad debts, all that will do is provide (admittedly much needed) capital to the giants of the financial service industry. This may help to stem the panic in global markets, but it won't help homeowners. Nothing in Paulson's initial plan gives the government the power to modify mortgages to reflect their current market value after they are purchased.
What happens if Congress grants the Treasury unprecedented authority to buy up bad debts without requiring restructuring of the underlying mortgages where possible? Millions more families will face foreclosure, further hammering home prices nationally and further eviscerating more household wealth. The crisis will not end.
As the Center for American Progress has argued for nearly a year, without addressing stability at the neighborhood level, our national (and now international) economic troubles will only worsen. That's why Congress needs to make some sensible additions to the Paulson plan.
First, Treasury must be granted authority to buy whole loans or pools of loans out of existing mortgage-backed securities trusts. Leaving loans in the trusts, and buying up tranches of the securities, will not give Treasury the leeway it needs to modify troubled mortgages.
Second, we need to change the trust agreements that are blocking real mortgage restructuring through sales to Treasury or new lenders who are willing and able to restructure the troubled mortgage loans. To accomplish this, the special tax benefit these pools enjoy as so-called Real Estate Mortgage Investment Conduits, or REMICS, must be forfeited unless the trust agreements are modified to permit participation in the Treasury program, as proposed by CAP Senior Fellow and former Treasury official Michael Barr.
Third, experience in the real world also shows that the legislation must also provide for a "cramdown" on second-lien mortgage holders, who have blocked many modifications hoping that they could extract payment on their often worthless liens by driving a hard bargain. With a cramdown, second-lien holders will get paid at a fraction of the discount the first mortgage holder receives, reflecting the higher risk they took to begin with.
By modifying the Treasury plan, Treasury will have the power to restructure eligible mortgages for owner-occupants under consistent, fair standards designed to provide most borrowers the chance to stay in their homes.
The bad polices of the past eight years have brought us to an unprecedented highly volatile housing market, with no certainty that even $700 billion buying bad debt will stabilize anxious markets. The administration's proposal means we could well end up with Wall Street's investment houses bailed out while more American families are driven to foreclosure and bankruptcy.
David Abromowitz is a Senior Fellow at the Center for American Progress. Andrew Jakabovics is Associate Director of the Center's Economic Mobility Program. This post originally appeared on the CAP website www.americaprogress.org.