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Taking Charge

The following proposal provides a way to:

- end the mortgage meltdown
- halt the precipitous rate of decline of real estate values
- leave banks able to lend to each other, issue mortgages and credit
- avoid the problem of valuing individual assets such as sub-prime mortgage bundles
- avoid the creation of a "Bad Bank" or nationalizing banks
- offer additional stimulus options and prevent the mortgage meltdown from putting a drag on stimulus and economic recovery
without any cost to taxpayers.

...tell your elected Federal representatives
(U.S. House of Representatives, U.S. Senate)

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All mortgages issued since deregulation (and any others bundled with them) are proposed to be nationalized via Fifth Amendment takings, consolidated into a Federal Mortgage Holding Corporation (MHC), shares of which are issued to mortgage holders as compensation according to formulae accounting for initial value and yield (as a proxy for default risk assessed before the meltdown.)  Unbundling becomes trivial, and credit-default swaps referring only to included collateral are simply proposed to be dissolved on expiration or terminated immediately with prorated premium refund from issuer, in either case eliminating this burden in the financial sector.  Defaulted mortgages owned by the MHC are not sold but instead converted to rentals, whereby downward pressure on the real estate market is removed; defautees able to afford market rents are given preference, and may be offered options to rebuy.  Further, conversion to rentals prevents vacancies being vandalized or gutted and blighting neighborhoods, instead being properly maintained, whereby this problem for communities as well as the real estate market is eliminated. The MHC can hold foreclosed properties for extended periods until they recover their value, being sold only as market capacity allows.  Financial institutions holding MHC shares are enabled to use these towards their capitalization requirements without the uncertainties of bundling or risk assessment, and are thus better able to lend; transparency and risk reduction eliminates the paralysis of interbank lending due to interbank suspicion.  Financial institutions presently servicing mortgages may be contracted by the MHC to service MHC holdings, conditioned on their issuance of new credit.  The MHC may adjust mortgage rates to compensate for deregulation-related abuses and to reduce foreclosures, reducing asset risk in favor of attempting to maintain fictional yields, since the MHC is not subject to short-term pressures faced by financial institutions.  Additionally, payment deferrals may serve as a tool for economic stimulus, with any associated costs balanced by extending the holding period to realize greater appreciation after the real estate market has recovered.  Payment deferrals may also be used as a form of unemployment assistance (at lower real costs compared to unemployment benefits which add to the federal debt).  Foreclosures not rented to defaultees may be rented or sold to public sector employees on favorable terms as incentives or benefits for this type of employment.  As real estate values recover, the MHC may then gradually sell off holdings at a rate which does not depress values.  Various strategies for making government action less intrusive and offering fair compensation are included.


Immediate and ongoing problems resulting from the mortgage meltdown are uncertainty over the distribution of default risk, the resulting reluctance of financial institutions to issue credit and consequent restriction of economic activity due to lack of credit even for sound borrowers.  Anticipation of continued declines in real estate values due to high and increasing foreclosure rates further restrains purchases in this sector; given the large role that real estate plays in the household wealth and creditworthiness of the middle class, a halt and reversal of real estate declines would facilitate recovery of the wider economy including employment, and thus greatly facilitate reversing the downward economic spiral of defaults, foreclosure, credit tightening, losses and layoffs.  While probably insufficient to cause economic recovery, rectifying the problems in real estate and the financial sector are likely necessary to undelayed economic recovery.

The critical factor at the root of the mortgage meltdown was deregulation, a failure of government to restrain excess leverage, prevent perverse incentives and require sufficient transparency.  Schemes for addressing this crisis generally approach the problem with a view of government acting as the largest available economic agent able to expend larger sums of money than any other, rather than as a non-market actor with capabilities qualitatively different from financial institutions, and so miss better solutions.
Results thus far from government efforts directed at reversing the economic downturn are sufficiently lacking that it appears necessary to suggest a strategy alternative to those now under public discussion.  In contrast to the proposals of creating a "bad bank," buying non-performing mortgages under the TARP, or of nationalizing banks, all of which are uncertain and problematic, the present proposal directly addresses the origins and dynamics of the crisis and takes advantage of the options uniquely available to government as a non-market actor, able in particular to take into account and act on long term values and objectives of public interest in the face of market instabilities, distortions, overshoots, misvaluations, etc.,.
Deregulation initiated the crisis, and shaped the ensuing markets for both real estate and mortgages and so distorted the values of both, and so it is entirely reasonable to develop a strategy which embraces the full breadth of mortgages issued since deregulation.  All mortgages issued since deregulation are proposed to be nationalized and held by a government created corporate entity, shares in which are issued to mortgage holders as compensation in a Fifth Amendment taking (and various formulae may be used to arrive at presumed valuation, vide infra.)  At once the problem of bundling is dissolved, at no cost to taxpayers.


It is emphasized that presently non-troubled assets are justifiably included because a large portion of post-deregulation mortgages were created and valued according to a distorted market.  If economic recovery is delayed, more of these will in any case become troubled assets, whereas through the present proposal these form part of the solution and their inclusion serves to prevent the moral hazard of informed actors aware of market dysfunction anticipating profit from crisis.  Since a taking is a significant exercise of government power, certain alternatives could be offered.  First, instead of MHC shares, mortgage-holders may elect for compensation in cash or U.S. Treasuries, in which cases corresponding MHC shares become possessions of the U.S. Treasury and entail value backing issued Treasuries or printed money. Second, one implementation option would permit mortgage-holders to be given the option of exempting assets from taking if and only if they can document the proper assessment of their risk, that they have sufficient capitalization (by pre-deregulation standards) to meet this assessed risk going forward or obtain sufficiently capitalized insurance from a private third-party going forward--in essence, meeting pre-deregulation requirements--and in addition with explicit disclaimer of future government insurance or assistance connected with exempted assets.  It is not expected that a large fraction of post-deregulation mortgages will be exempted.
In the foregoing, non-failed banks are not nationalized, but both liabilities and assets connected with the mortgage meltdown are removed from their books.  This removes the hazard of socializing costs while privatizing profits, but leaves them in business with whatever capitalization they otherwise have.  In general, takings compensation can be either in shares in the MHC based on outstanding principle or if in cash equivalents start from a discount based on the presumed arbitrary market-wide default rate, say 20%, adjusted in either case for particular mortgages according to the purported yield of mortgages before the meltdown, which reflects the options available to borrowers at the time loans were made and thus is a reasonable proxy for initial risk.  (Note that the presumed default-rate discount should be arrived at through extensive market analysis, not attempted here.)  Since sound borrowers could obtain more traditional, lower rate fixed mortgages, these are presumably the least risky, while high rate or exploding mortgages and other exotic instruments obviously carry greater risk and should be valued lower.  Given the proportion of homes presently valued at less than their outstanding debt, and the fact that the present economic crisis is turning sound borrowers into default risks, in the foregoing example accepting MHC shares would likely attractive to mortgage holders.   

Although there will no doubt be some complaints about any valuation lower than face value, in practice this solution offers lower losses to most mortgage holders than could be expected from other proposals presently being discussed, and successful management of the MHC could yield a long-term results approximating full face value for all but the most risk-laden mortgages, which deserve no special favor.
The government mortgage holding corporation (MHC) may then do what banks can't, namely hold these assets as long as it takes for the real estate market and mortgage securities markets to recover whether or not borrowers perform--selling off assets at any market price no matter how depressed is not necessary to meet short-term cash flow in this case.  Here it is noted that the average home purchased in 1929 in the U.S. before the market crash recovered it's purchase value within 20 years, which is less than the term of conventional mortgages.  As the mortgage owner, the MHC may adopt a number of financially sound measures banks would be reluctant or unable to take but which would both serve public aims and help resolve the crisis.
First and foremost, sale of foreclosed properties into a collapsing and undervalued market may immediately be halted, and instead of vacant foreclosures being looted or vandalized or falling into disrepair and leading to blight or worse, they may immediately be converted to rentals, with a preference for rental to those defaultees who can afford to pay reasonable rents, who may also be offered options to rebuy some number of years hence.  Extended holding periods avoid problems seen in the Resolution Trust Corporation unwinding.  
The MHC would preferably contract mortgage servicing to banks with experience in this field, but with eligibility requirements such as active issuance of new credit, whereby an incentive to unfreeze the credit market is created.  As for foreclosed properties converted to rentals, instead of direct government management, one option is to contract management to private sector entities, letting tenants chose the management company from among eligible management companies in a region for a fixed term, and with compensation for management based on direct costs and realizing savings targets for the MHC.  Tenants are given the ability to rate their management company's service so that ratings create reputations informing choices in this rental market.  In such an arrangement, tenants have market-type choice to enforce reasonableness on management, which must be selected by renters in order to get business in the first place, while management has an incentive to reduce costs to government.   
The remaining issue seldom discussed in various approaches to the crisis concerns an implied threat by the People's Republic of China to cease purchase of U.S. Treasury Bills if mortgages purchased by Chinese institutions which were purported to be as secure as U.S. Treasuries are less than secure.  A sudden cessation of such purchases would pose significant problems for the U.S.  This is a matter governed not only by economic considerations but impinged upon by considerations of national security and foreign relations; unfortunately, to address these challenges requires that not all mortgage owners be treated equally.  Provided that the foregoing proposal is effective and halts the economic downturn (which has already had deflationary impacts) it is probably feasible to make up devaluations of Chinese owned mortgage assets from par by payments made by the U.S. Treasury effectively increasing the money supply, either by issuing Treasury Bills or printing money.  Most simply, Chinese-held mortgages may be traded at full non-defaulted mortgage value for U.S. Treasuries instead of MHC shares, which for the corresponding assets go to the U.S. Treasury and provide value to back Treasuries created for this purpose.  This could be compensated by or conditioned on commitment to future purchases on U.S. Treasuries, and such arrangements could in fairness be offered to other large purchasers of U.S. Treasuries.  MHC holding periods may be extended to realize greater long-term appreciation to offset any resulting real costs, and since most of the money or securities created by the Treasury are backed by the long-term value of the MHC shares involved, this operation is not particularly inflationary.   

With these aspects of the financial crisis addressed, the credit system is no longer encumbered and can play its proper role in economic recovery, and stimulus measures can be more effective than they would be if the economy continues to be saddled with mortgage meltdown-related liabilities.

©2009 Hard Times Survival Corp.