Some banks gave mortgage loans to people who cannot keep a house under any conditions. These so-called toxic assets paralyzed the banking system, as now no one knows how much the banks are worth. With banks being essential for the economy to function, the government is allocating a lot of money to protect them from collapse. The same, the recession caused by – let call it as it is – a pyramid scheme lending spree, is affecting everybody. In particular, unemployment increased and many people that are still employed do not earn as much as before. As a result, many of them fall behind in paying their mortgages, deepening the crisis.
We know that as it has happened many times before, eventually the economy will bounce back. The objective is to find a solution that would allow avoiding foreclosures for those homeowners that, under less stressful circumstances, would be able to pay their mortgage on time. Unfortunately, no one can help in those instances where a mortgage was issued on fraudulent documents to a person that has no means to make the payments.
Pumping money into a black hole on Wall Street will not do it. Only a handful can see and understand how this money would be used. Furthermore, it means giving money to people who got us into this mess at the first place. It is not right; it is not wise either. Banks evolved into gigantic financial dinosaurs and some of them need to die as the dinosaurs did. Quite simply, we should not have banks so big that a failure of a few of them could kick the nation’s economy out of balance. However, given the current distress, it is not the right time to reform banks.
The most that the government can do to help homeowners is to buy them some time so banks can figure out among themselves how much they are worth. The simplest way of buying time is by issuing ad-hoc emergency loans to individuals who cannot afford to pay their mortgage. By issuing these loans, the government would guarantee that not one house would be foreclosed upon within the next six months, but the next six months only. Within this time, banks would figure out the real value of their assets. Some banks would go down, some would split, and some would find ways of handling their toxic assets.
By paying all defunct mortgages for six months, the government would extend the solvency of the current banking system. However, banks would administer the government’s emergency loans. By doing so, they too would have an additional six months: but to review case by case all their troubled mortgages. On some, they would give up and write them off. On others, they may be able to refinance the loan on better terms. By the end of the six-month period, banks will know the value of their assets much better.
For individuals who would be able to pay their mortgage after receiving the six-month government loan, banks would repay the government within a short term, and would incorporate this debt into their clients mortgage or equity line.
If an individual receiving an emergency loan to cover mortgage payments were to fail to pay his or her mortgage after the six-month period, his or her bank would repay the government first before getting any money from the foreclosure. This would be beneficial to banks as well. Today, with so many foreclosures and the recession, housing prices are falling off a cliff. A house priced $300,000 two years ago could be worth as little as $150,000 today. Six months of mortgage payments on the $300,000 loan is anywhere between $10,000 and $15,000, depending on the interest rate. We should expect that with the stimulus package and with the government plan assisting homeowners, the economy will bounce back within the next few months. Housing prices would follow suit. Instead of a fire sale for $150,000, a bank might be able to sell the same house six months later for $180,000 or more. Even after paying back the government emergency loan, it would lose less than by selling this house today for $150,000.
Assuming that the government would need to assist 9 million failing mortgages and assuming $1,500 as an average monthly payment, the government would need to assign $81 billion to this project. In his plan, President Obama assigned $75 billion for assisting homeowners. However, for his plan to function, additional $400 billion need to be pumped into Fannie Mae and Freddie Mac. It is – again – saving dinosaurs, giving money to the financial institutions that brought this crisis upon us at the first place.
Comparing with the plan proposed by President Obama, with the implementation of this concept, the government does not need to get involved into the nitty-gritty of the banking business. It will just open a credit line for banks to draw against defunct mortgages. The burden of repaying these loans will be on banks, not on the homeowners. The government does not need to create any bureaucracy to assist homeowners in distress. The government would put banks in the position such that speedy finding a mortgage option that the house owner can afford is in the best financial interest of the lending bank. With this mechanism, one may expect that banks will draw much less than $75 billions. Furthermore, all these funds will be clean shot short-term loans; not giveaways like Wall Street got.
Additionally, with this solution, we do not need new – raising controversies – laws giving judges powers to rewrite mortgages.
By offering short-term loans, the government would be using taxpayer money wisely to stimulate banks to reform their lending practices, and would help those citizens that fall into trouble not due to their mistakes.
The beauty of this concept is in its simplicity; everybody can see how the money would be spent. Lastly, it is so simple that no one can screw it up in implementation.
A version of this text was published by Huffington Post