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Mortgage Crisis, Recession, and Bailout: Reconciling the Numbers Print E-mail
Written by Bruce R. Copeland   
Tuesday, 20 January 2009 19:36

Four months into a recession spawned by the mortgage investment banking crisis, it is worth doing some basic math on the real costs.

First some background: I supported the original treasury bailout, albeit with two important qualifications. First, I wanted the proposed $750 billion bailout to be authorized by Congress in three chunks of $250 billion instead of two chunks of $375 billion. Second, I noted that the projected actual losses from home foreclosure (at that time ~$200 billion) were a fraction of the total $750 billion requested by Dept. of Treasury for bailout. I suggested it would be safest in the long run to use the bulk of the bailout to buy up troubled mortgages or their underlying properties.

With an intensifying recession, I regret not pushing harder on these two points, or at least I regret that my congressional representatives and their colleagues didn't listen better. The incoming Obama administration has proposed that as much as $800 billion of stimulus may be necessary to deal with the recession (on top of the $400 billion of TARP that the Bush administration has spent). Other estimates of recessionary losses are as much as $1400 billion (10% of GDP) for a severe recession. Conversely, estimated losses from failed mortgages are still only $250 billion. So how did $250 billion morph into $1200 billion? What went wrong? Well, several things. First, many of the original TARP recipients simply failed to deliver on their promises to increase lending. Second, the rest of us pretty much panicked.

As individuals we don't make financial decisions based upon the Federal Reserve's macroeconomic plan for an optimal economy. We make decisions based upon what we perceive to be our immediate risks. When we hear about employers laying off people because they cannot get a short term loan to make payroll or we hear that retail sales and small business contracts are drying up, we assume we may be next. Naturally we start looking for every possible way to save money—cheaper groceries, fewer DVDs, less travel, etc. The trouble is that this behavior is only productive when most other people ARE NOT doing it. When everybody tries to do this, it causes a downward spiral into severe recession or depression.

So what can we do now?

1) Get with the program or bust. This is what we need to tell the recipients of TARP I funds. They have three choices: demonstrate that the bulk of TARP funds they received are going towards qualified credit (small business loans, sound mortgages, good entrepreneurship...), return the funds, or be taken over by the federal banking system. Allow banks which pass this step to participate in 3). Carrot and stick, carrot and stick...

2) Buy up the bad mortgages. Use stimulus money to refinance failing mortgages at 12% above current market value for the property. If the current mortgage holder refuses, threaten either eminent domain or a blight tax on empty or run-down property. Negotiate hard and don't accept no as an answer. Make it too expensive for either party to walk away from the deal. Encourage the mortgage holder to recover some of their remaining loss from the brokers and appraisers who set up the original sale. Provide some resources to achieve this. There are entire mortgage divisions of some national banks which I hear the banks would love to divest. Carrot and stick, carrot and stick...

3) Get good banks to compete for the next round of TARP funds. It may surprise you, but there are quite a number of sizeable, healthy regional and state banks that weren't involved in the mortgage meltdown and have a good track record for fiscal responsibility. The U.S. Government needs to contract with these banks ASAP to make small business payroll loans, import/export loans, etc. to get our economy back on track. Allow these banks to make a reasonable return on loans. If some of the national banks got past item 1), have them compete too! Forget the other big national banks that spawned this crisis and are still too paralyzed by fear to make rational decisions. Carrot and stick, carrot and stick...

4) Take a deep breath and start living again. Most of us haven't lost our jobs or our businesses. We need to stop acting like we have! I don't mean spend money frivolously, but spend normally. If you know someone who really is struggling, consider hiring them to clean out that garage or attic you've been meaning to deal with. Offer to share a garden. Go fishing or camping together. Find worthwhile projects or charities to support in your community. There are lots of great deals on the stock market—invest in sound companies that weren't involved in the mortgage meltdown.

In short we need to get hard-nosed about fixing the real problems, and we need to start behaving normally about everything else. Oh, and those people in Washington (both parties) need to begin thinking seriously about basic math involving real costs!

Comments (2) Comments are closed
1 Sunday, 08 March 2009 18:58
- Solve the loan problem.
- Solve the derivative problem.
- Reassemble whole loan mortgages

The U.S. economy is shrinking fast, because businesses cannot get loans that they need to operate normally. Banks and lenders already own $ billions in bad loans, and they are afraid to make new loans. The government gave $ billions in bailout money for banks to start lending, but banks hoard the money to save themselves.

Our financial system became untrustworthy, because it mixed $ billions in bad loans in with the good loans. Now, banks do not trust any of the loans, and the entire credit market stopped working.

The U.S. economy will continue to shrink until we untangle the loans. Once the bad loans are isolated, they can be fixed one at a time. Then trust will be restored. Credit will flow, and the economy will grow.

So far, our government is spending $ trillions on bailouts and pork projects, out of ignorance and political ideology. The real solution is much less expensive than that.

The USA has fixed this problem before, and it is not hard to fix again. This is how:

A) Start with the Resolution Trust Corporation (RTC), which the federal government setup to solve a Savings and Loan problem in the 1980s.

B) RTC buys up securitized mortgages and derivatives to reassemble whole mortgage loans.
1. “Securitized mortgages” are home loans that have been bundled into large groups and sold to investors. A group of about 4,000 mortgages can be “securitized” and sold just like a stock or bond. Investors like to buy groups of mortgages because they receive all the monthly house payments.
2. Some groups of securitized mortgages were subdivided into smaller pieces, called “derivatives.” However, both of the fancy names refer to mortgage loans.
3. The problem is that many bad loans (with no payments) got mixed in with good loans. That turned the all the securitized mortgages into bad investments, which are ruining our banks. It is a huge problem, and the government has to fix it, before our economy will recover.
4. Total securitized mortgage and derivative market is estimated at $1.3 Trillion by a Professor of Economics at Ohio State University. (Also see the graph from Deutsche Bank at “The Death of Securitized Mortgages” )
5. Government should buy up securitized mortgages and derivatives at the lowest market price, which is set via a reverse auction. (Google on “reverse auction”.)
6. Squatters, who sit on their mortgage derivatives, in order to extort big $ from the rest of the system, can be forced to sell. (Law is analogous to eminent domain, or sales forced on cybersquatters that registered the domain names of well-established companies.)
7. Government pays mortgage derivative squatters at market price set by previous reverse auctions, perhaps with a penalty to the squatters.
8. Sellers give up all rights. No new law there.
9. Banks, investors, and insurers now have cash instead of questionable mortgage loans and derivatives. So, the banking system is healthy with cash to lend.
10. Credit will flow, and the economy will grow.

C) Government reassembles whole loans from securitized mortgage components and derivatives.

D) Government sorts the newly reassemble whole loans (mortgages) into groups according to risk/quality.
1. Government uses traditional mortgage experts and guidelines to sort the home loans into quality groups, for example, a high quality group would include homeowners with 20% (or more) equity in their house at today’s market price; and house payments that are 25% (or less) of homeowners monthly income.

E) Government (RTC) sells the reassembled whole loans to traditional mortgage banks.
1. This solves the problem of renegotiating home loans with homeowners. Read on.
2. Law must be changed so that reassembled whole loan mortgages cannot be securitized into derivatives, again.
3. An important purpose is to reconnect each homeowner with his lender, and vice versa.
4. It eliminates incentive for mortgage lenders to make predatory and junk loans. If the loan fails, the lender is stuck with a bad loan.
5. Government recovers much of the $1.3 Trillion purchase cost, because government auctions off the reassembled mortgages.
6. The lower quality, more risky mortgages would fetch a lower price at auction.
7. Mortgage companies, that buy the risky loans, will have more room to negotiate with the homeowners.
8. Some homeowner negotiations will not succeed. Those homeowners will move into affordable rentals. (The government does not owe everyone a free house.)
9. Other renters would like to buy those empty homes at reduced market prices.
10. If the government gets stuck with some homes, the government could profit by selling the homes when the housing market recovers.

F) Insurers like AIG may be reorganized through bankruptcy.
1. Securitized mortgage pools never made business sense, unless they were protected by various insurance schemes.
2. Those insurance schemes always were a scam.
3. Insurance only works when most of the insured assets are never hit with a disaster. That is why flood insurance does not work very well. A major flood ruins all the buildings in a large area, all at the same time. So, the insurance company goes broke, and people that bought the insurance are not protected. That is the problem with securitized mortgage insurance. In an economic downturn, the “disaster” hits all the houses at the same time. Securitized mortgage insurance was doomed to fail, and the insurance companies went broke in 2009.
4. Companies that ran the insurance scam may have to go through bankruptcy.
5. Never ending government bailouts for insurers like AIG are just throwing good money after bad. So, stop the bailouts.

This plan is inexpensive, tried and true. It leaves the banks healthy, with cash to lend. It restores trust in the credit markets, so loans will be made. It reassembles mortgage derivatives into whole loans, and restarts traditional mortgage lending. People can get loans to buy homes. Credit will flow, and the economy will grow.*


*The economy will grow if President Obama’s massive tax, borrow, and spending plans can be stopped, before he creates another Great Depression. Presidents Hoover and Roosevelt already tried to tax, borrow and spend their way out of a recession in the 1930s. Instead, they created the Great Depression, which lasted 12 years. Straight as he goes, President Obama is doing it, again. Nevertheless, cleaning up the securitized mortgage mess is a necessary first step.

If President Obama announced Steps 1 and 2, today, the stock market would go up within hours. Investors love a real business plan, instead of a political pork plan. Millions of people will be wealthier, feel wealthier, and have money to spend. That is how to jump start the economic recovery within days.
2 Saturday, 14 March 2009 11:25
Guys Background Search:

You are largely correct about the need for something like step 1. Many factors contributed to the housing market meltdown and high mortgage foreclosure rate. But it was the slicing and dicing of mortgages into securities that really produced the current crisis. Most of the investment world knew about the housing and foreclosure problems by summer of 2007. The crisis only occurred (over a year later) when everyone discovered all the weak mortgages were divvied up with the sound mortgages. This commingling and dispersal of mortgages (by design) made it impossible to properly value the various mortgage securities, and it (also probably by design) left no functional mechanism for investors, struggling homeowners, and courts to negotiate reasonable (and cost effective) solutions for the weak mortgages. The decision to slice and dice mortgages was a fraud perpetrated on investors. Ironically it caused the downfall of many of the same perpetrators. [When the dust settles on this crisis, I personally think we should prosecute most of the individuals and institutions who sliced and diced the mortgages.]

However, $1.3 trillion seriously underestimates the total securitized and derivatized mortgages. Today most mortgages are securitized, so the estimate of $1.3 trillion is probably low by a factor of 5 to 10. This poses a problem for step 1 as you have described it, since the government would have to buy up more than $7 trillion in mortgage securities to fix the problem. Still I think it should be possible to force all mortgage security holders to submit their securities for cleansing along the lines you suggest. It is a radical solution, but one that is certainly preferable to the alternative for the holders of those securities.

Step 2 is a lot more complex than you (or anyone else) really wants to acknowledge. If the Bush Administration had promptly carried out step 1, there would today be no need for stimulus. However six months have passed with only barely functioning credit markets, and because of that, the damage from the financial and housing sectors has spread to other originally healthy sectors of our economy. With it has come panic. Like it or not, there IS a bona fide psychological component to economics. A certain amount of stimulus is often necessary to minimize and reverse a recession. Is the current stimulus enough, too much? I don't know. I'm not happy about the amount of junk in the stimulus package, but frankly that junk came from BOTH parties. A lot of it is long horizon stuff that really does very little to perk up today's scared workers, consumers, and investors.