09/30/2008 02:21 pm ET | Updated May 25, 2011

Pelosi's Price

A very dubious Wall Street rescue package went down to defeat Monday because the Republican leadership double-crossed the Democrats. Neither party was thrilled with this bill--it might not work; it was too tilted to Wall Street; constituents were outraged. So the deal was that both parties had to share responsibility.

Pelosi's understanding was that the Republican leadership would produce at least 80 of the 199 Republicans in the House. Pelosi would then produce the necessary 138 Democrats to cobble together a bare partisan majority.

But Monday morning Republican whips told their troops that they considered this a "vote of conscience"-- permission for Republican rank and file to vote no. This allowed the very same legislators who have been Wall Street's prime enablers to do a 180 and pose as indignant populists. And this mass defection occurred before the Pelosi speech that Republicans are widely blaming for the increase in Republican opposition. In the end, only 66 Republicans agreed to support the bill-and Pelosi wisely refused to let this very badly flawed legislation be mainly the Democrats' handiwork.

Now pressure is mounting to try again. But, after this flagrant bout of Republican bad faith, the situation doesn't just revert to the status quo before Monday's vote. So what should Democrats demand as their price for coming back to the table?

Many proposals have been offered by progressive economists. But the most important, simplest to grasp, and most difficult for Republicans to oppose, is direct government refinancing of distressed mortgages.

We could revive Roosevelt's Home Owners Loan Corporation. It could refinance mortgages, taking advantage of the government's very low borrowing rate. If struggling homeowners got, say, a 4 percent mortgages, most could afford to keep their houses. That in turn would brake the collapse in housing values.

Instead of trickling down, the benefits would trickle up. When a mortgage was refinanced by the government at, say, half its exorbitant sub-prime rate, the bondholders would get fifty cents on the dollar for being relieved of their bad paper. This is similar to what Paulson expects, but in this case homeowners would be helped first, and the help would be assured.

Benefits: it's easy to understand; and everyone grasps that it helps Main Street rather than Wall Street-not as a possible side effect but as the main idea. And imagine Republicans, who only yesterday were crying that the bill didn't do enough for the average American, opposing this approach. Forcing them to take this vote would produce useful public education. In the end, Democrats, if they had to, could pass the legislation with only Democratic support-and have a bill they could be proud of.

The other benefit is that if the government used its money to refinance mortgages rather than buy up bad paper, the government will get paid back. Here is the arithmetic. If there are two million mortgages held by owner-occupants at risk of going into foreclosure, and the average mortgage is $300,000, the government can refinance the whole lot for $600 billion. Since the government collects interest on these mortgages at a point or two above the Treasury's own borrowing rate, the government will actually make money on the deal, as the original Home Owners Loan Corporation of the 1930s did. Net cost to taxpayers: zero. We could still give Paulson a couple of hundred billion for other emergency rescues, and the whole net cost would be much less.

As even Paulson admits, at the base of the shaky pyramid of bad paper are mortgages that were made on terms homeowners could not afford. The typical sub-prime mortgage begins with the "teaser" rate, and then after a couple of years rises to eight or ten or twelve percent. The borrower hopes to refinance, but finds too late that the mortgage contains heavy prepayment penalties.

As these mortgages have defaulted, the bonds backed by the mortgages lose value, and then the insurance contracts written by giants like AIG against default also take a huge bath. Paulson's idea is to rescue the banks by buying up the bad paper. He hopes that the "servicers" who collect monthly mortgage payments could then give the at-risk homeowners a break on the payments. But this is nowhere guaranteed, and the remaining private bondholders could still sue the servicing companies for modifying the terms. The Democrats got into a losing battle over their idea of allowing bankruptcy judges to approve modifications. This, however, is a Rube Goldberg solution that voters don't understand and that would only string out the process. The epidemic of foreclosures would continue.

Direct government refinancing of distressed mortgages is far better economics and far better politics. Various people inside Congress and out are pitching Pelosi on this idea as the price of her willingness to try again. Let's see what the Speaker is made of.


Robert Kuttner, co-editor of The American Prospect and Distinguished Senior Fellow at Demos, has just published Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency (Chelsea Green). He is blogging daily about the election and the economic crisis at