Neither Fair Nor Effective

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.

Comments

[Tellurider]

I like the idea of offering a one time opt-in or opt-out opportunity to put a "deed restriction" on your home with a 3% cap rate per year on appreciation when you sell it. This would keep the homes affordable for "WORKFORCE HOUSING" forever.
As part of the plan, the existing mortgage would be lowered by an appraissal which accounted for the lower value of a "deed restricted" home verses a "free market" home (30 to 50%) with full appreciation potential.
The delta between the different values would be paid for by the Federal Government (which caused this whole mess) in the form of tax credits to the lender.
This would launch a national "workforce housing" program which is desperately needed as our essential gainfully employed i.e. teachers, nurses, firemen, police, etc. are finding it impossible to buy a home anywhere near to where they work because wages are not going up as fast as home prices.
The Plan would not be a bail-out or give-away, but fair payment to homeowners that agree to "deed restrict" their homes and put them in a national workforce housing program
This would stop the foreclosures, stop the bank failures, clean-up the enormous inventory of homes and put America back to work.
People would then a home, a home they could afford.

[NWNHNM]

At a bare minimum, the Paulson plan should be amended to give the power to spend the taxpayers' money not to Paulson and his cohorts but to a person appointed by Barack Obama. Under no circumstances should power be given to anyone appointed by George W. Bush.

[jake1492]

The effects of such a plan would be vastly better than one proposed by the treasury secretary. It would share the pain between the mortgage holders, the financial institutions, and the general public.... who all have a stake in this. By contrast, the plan by investment banker Paulson gets the banks off scott free, gives all the risk to the general public, and all the immediate pain to the mortgage holders.

Paulsons "We need a clean bill..." means "give up ALL your leverage right now while emotions are running high so you can't do anything about this incredibly corrupt transfer of wealth later". Highly immoral. These people have no shame. Stand up to them Democrats! Put the bailout money at the mortgate holder level... in as fair a way as possible. Ameliorate the root cause of this problem. Then the banks have nothing to complain about... except the loss of an opportunity to stiff the public.

Obama-Biden 08!

[jake1492]

Although there are some very complex details to the situation, like the derivative instruments the banks have used as credit swaps.... the overal situation is quite simple.

There is a glut of non-performing mortgage debt that was established quite recently in the unsustainable housing bubble. Failure of the mortgage holders to be able to pay those mortgages is causing a wide swath of the financial industry to lose money through those instruments..... which is in turn causing stock market losses and loss of availability of credit to people and businesses.

The root cause of all of this is the non-performing mortgages. The solution to this problem is not the crack cocaine for the banks that Paulson is proposing.... but the meat and potatoes that would be addressing the root problem of non-performing mortgages. The scale of "public investment" being contemplated is adequate to support a fair, balanced arrangement where mortgage holders' debt and interests rates are reduced to managable levels (as an overal average).

[krocklin]

Too bad "Disaster Capitalism" can't work for once to initiate more egalitarian principles in the economy rather than just benefit the usual suspects.

[Overd0g]

These families made a bad investment. Tough luck. The solution isn't to send the bill to people who were responsible and didn't overextend themselves.

[KHAAANNN]

The investment banks made bad investments. Tough luck. the solution isn't to send the bill to the people who were responsible and didn't overextend themselves.

[minerva117]

But it's OK to bail out the fat cats who enriched themselves and walked away with millions. Why is it that the individual must take responsibility for their own mistakes and the fat cats can pass their bad debt on to us. And keep their millions.

[sirgorpster]

In the beginning, remember, the sub prime crises was caused by speculators and folks who lied about their income trying to capture quick bucks , etc.
But, the drop in housing prices seemed to cascade and started to affect other people.
So, it is too simple to say "tough luck" because the spiral can keep going - each month we have
been waiting for the bottom. Still waiting.
I think the bailout cannot bailout everyone but
there might be a way to keep some people in their homes. The investment banks were at the
other end of the deal and had "no clue" about the real quality of the paper - but also once the
values of the houses started to drop even their "good paper" do not look as good.
It is the fault - the root cause - has to be the loosening of the rules that allowed mortgage writers to be so friendly and so creative in drawing up inherantly bad bubble loans - just "legal" ponzi scheems.
Who loosens the rules? The government.

[technocrat]

Right. More is needed. This program can provide hope as well as relief.
Hope for families, neighborhoods, communities, employment, the economy, the environment and energy independence.
A public lender cares about families and is not going to rush through a foreclosure as quickly as possible just to get the property off the books.
A public lender cares about neighborhoods and makes sure vacant property does not become the cause of blight.
A public lender cares about communities and maintaining the tax base to support local services.
A public t hires contractors who employ local labor to restore and rehabilitate the foreclosed properties it acquires.
A public lender will absorb excess housing stock by removing substandard housing stock through land banking.
A public lender that cares about the environment will make the housing stock it owns greener.
A public lender will use its land banked properties to promote housing opportunities closer to jobs and public transit to cut down on the need for long distance automobile commuting and the oil it requires.
A public lender doesn't solve every problem related to housing, communities, the economy and the environment. It should not be made permanent without a great deal of thought and debate. We ought to require this measure to do more than to just get rid of a Wall Street problem.

[January]

Thank you for the concrete proposals. Most commentaries amount to bitch sessions. Yes, Paulson's plan is a pig in a poke. And Paulson's plan is only a pale reflection of what got us to the predicament we are in.

Commentaries full of what we ought not to do are half-a**ed. It's a contradiction when only making mortgage money available will get the flow going and yet neither the prices of property nor the value of paper assets are stable. How can we have stability in the midst of chronic instability?

We need concrete proposals as in this article.

[Eafloaf]

The Democratic Congressional majority and, if you believe John McCain's latestinca­rnation--M­ccain and his supporters, will support modification of the Treasury proposal to reflectthe principles espoused above. Tougher will be the formulation of a detailed approach and execution thereof in order to expeditiously tackle the problem on Main Street.

[wandering girl]

Paulson's got his work cut out for him. even as details are being forged, the fat cats are trying to gouge a profit out of this bail out:

http://www.nytimes.com/2008/09/22/business/22lobby.html?ref=business

headline is "Big Financiers Start Lobbying for Wider Aid"

"Even as policy makers worked on details of a $700 billion bailout of the financial industry, Wall Street began looking for ways to profit from it.

Financial firms were lobbying to have all manner of troubled investments covered, not just those related to mortgages.

At the same time, investment firms were jockeying to oversee all the assets that Treasury plans to take off the books of financial institutions, a role that could earn them hundreds of millions of dollars a year in fees.

Nobody wants to be left out of Treasury’s proposal to buy up bad assets of financial institutions.

“The definition of Financial Institution should be as broad as possible,” the Financial Services Roundtable, which represents big financial services companies, wrote in an e-mail message to members on Sunday."

read the whole article for more information.

[larry278]

David & Andrew will get their wishes from Prez Obama. W & Co are much too stunned to see what has happened, let alone aid in the rescue & prevent future occurances of melt down conditions. Their ideas are good. Their cautions are based upon both very recent & past experiences.
Any steps Paulson takes will be reviewed & revised by BHO's White House operatives to include the measures this blog proposes.
The nation is too damned scared to vote for McCain/Palin. Sep 15, 2008 was what used to be called a wake up call. Everybody got the call.

[lemonyashes]

I hope everyone got the wake-up call. Paulson's rush on this is scary. Someone has to say wait a minute! Perhaps this is just one last payout to the fatcats before they lose to the Democrats.

[67]

I agree with you and your post Paulson should resign immediately . he should not hold a position in the federal goverment,also the GOP should hold their heads in the sand and be pissed on by a herd of Elephants,way to much B.S. over the last eight years