Treasury Secretary Timothy Geithner has unveiled a new plan to combat the financial crisis: persuading private financial institutions to buy up toxic assets with the government's backing. While this is a step up from former Secretary Henry Paulson's original bailout plan — in which the government itself would buy up the bad securities — it is still not the right approach.
Instead, there is a better, cheaper, less risky, more direct way to improve banks' balance sheets and restore confidence. Here's how:
Reduce the outstanding principal on every single mortgage to, say, 70% of the original value. Yes, you read that correctly: lower every American homeowner's mortgage debt by a fixed percentage. (See 25 people to blame for the financial crisis.)
If homeowners owe less money on their mortgages, they will be less likely to stop making their payments. The plan is equivalent to a universal renegotiation of terms that improves the situation for both homeowners and banks. As a bonus, mortgage-backed — and, indeed, all mortgage-based — securities will become less toxic by virtue of a trickle-up effect.
Experts have pointed to a $30.6 billion deal between Merrill Lynch and the Lone Star group of private-equity funds as a model for the new government plan. Lone Star purchased that amount of Merrill Lynch's portfolio of asset-backed securities, and Merrill Lynch reduced Lone Star's risk by financing three-quarters of the purchase. Therefore, Lone Star had limited risk, which is similar to the way funds would have limited risk buying bad securities with government backing. But the most important part of the deal was not Lone Star's risk; it was the price. Lone Star paid 22 cents on the dollar. This means that Merrill Lynch had priced its asset-backed securities somewhere around 22% of their original value.
Geithner hopes to encourage private investors to buy these asset-backed securities, giving the banks cash and eliminating further downside risk to their portfolios. But why not try to make the securities more valuable in reality, so that investors want to buy them from the banks without receiving government support?
So far, the government has focused on trickle-down solutions: dealing with complicated assets like mortgage-based securities in the hopes of stabilizing the values of more concrete assets, like homes. In contrast, my approach addresses the root of the problem. Thus the government would help ensure that the mortgage-based securities find a stable price via the trickle-up effect. After all, it would take an inconceivable number of foreclosures at 70% of principal to justify the assets' trading down to 22% of their face value.
This plan costs the government — and the U.S. taxpayer — only a trivial amount, the operating costs. Again, it is nowhere near as complex as what the government has done so far. It carries a small price tag compared with the massive, mostly ineffectual spending that has been the basis of the current policies. (See pictures of the global financial crisis.)
Why lower the principal of the mortgages instead of reducing the interest rates of the loans? Because it creates far more incentive for homeowners to continue making mortgage payments. Moreover, with all the exotic loans out there, many with adjustable rates, the principal is the only standard across all mortgages. Adjusting the remaining principal, then, is the most general way to renegotiate all mortgages as equitably as possible.
Further, there is currently a crisis of confidence in the banking world. Because of the uncertainty surrounding the future of asset values and the prices of complicated derivatives like mortgage-based securities, banks are hoarding money. They lack the confidence even to lend to one another. Reducing mortgage principal addresses both of those problems directly. By stabilizing the mortgage markets, much of the uncertainty will vanish. Banks' balance sheets could stabilize. And confidence may very well return.
Implementation is the most difficult part of this proposal. While many financial institutions would immediately discount the plan, ultimately persuading them to accept it is not unreasonable. It is true that for those institutions that hold physical mortgages, their maximum potential profit will go down. For a 30% decrease in principal, the math works out to some $3 trillion potentially lost on residential mortgages as of mid-2008, according to the Federal Reserve. But if Americans keep defaulting on these mortgages and asset values continue to crash, the total loss to the financial world will be far greater than $3 trillion.
It is also true that the banks will probably want to discriminate: Why should they lower the principal on "good" mortgages? Why not just on those that are most likely to be foreclosed on? Thanks to the way the debts have been bundled and then cut into tranches, the good have been rolled together with the bad, and specialized renegotiation is easier said than done. That is why banks have not already renegotiated loans on a large scale. But with the government's pressure, lowering the remaining principal on every mortgage could easily become a reality.
The only banks that could legitimately lose on this are those that hold nothing but good mortgages or tranches of good mortgages, with no bad assets. Since the Troubled Asset Relief Program has attracted such interest from virtually every bank, we can conclude that such good-mortgage banks exist only in small numbers.
Other advantages of this solution are that it is universal and nondiscriminatory: every mortgage holder in the U.S. gets a break. Homeowners without mortgages also benefit, as foreclosures directly lead to deflated home values, and the number of foreclosures will be reduced considerably. At the same time, the banks' assets will have a greater inherent value: their balance sheets will improve, and they are likely to begin lending sooner than they would with the government's current strategy.
Unlike Geithner's plan, this solution is simple and transparent. It does not require the government to price complicated derivatives. It requires only one decision: by what uniform percentage principal should be reduced. And unlike all of the other plans out there, it does not require significant government spending. It is also politically palatable, as it does not discriminate and does not rescue certain institutions while leaving others to fend for themselves. Homeowners get the most direct benefit, and the solution is efficient because of its flat-tax-like nature. Just about everybody wins.