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9/20/2008 8:25:23 PM - A Solution to the Credit Crisis

The government is going to bail out the financial industry - and therefore supposedly resolve the current credit crisis - by purchasing roughly $700 billion in bad mortgages that would then be sold off over time. This comes after the government already backed JP Morgan's purchase of Bear Stearns (by having the Federal Reserve agree to accept $29 of the first $30 billion in losses), taking over Fannie Mae and Freddie Mac (which rational people always knew were problematic in that they took advantage of an implicit taxpayer guarantee to effectively obtain a lower cost of capital, were far too accomodating in terms of the types of loans that they would accept, and were allowed to maintain a far smaller base of capital versus the normal banking industry), and loaning AIG $85 billion so that it did not collapse and wreak havok given the intermingled nature of the financial industry.

The idea is that by purchasing the bad loans from the banks (in a reverse auction, whereupon the government would buy the those mortgages that are offered for the lowest price), the banks can then recapitalize themselves because investors won't be terrified of injecting additional cash only to see their stake diluted (or worse) when another wave of writedowns causes still more capital to be needed. The end result is that banks could get back to the business of lending - something that is vital to the economy, but in serious jeopardy when no one trusts anyone else because they don't know what the other party is holding on their balance sheet and how that might affect the borrower's ability to repay the loan.

I came up with a much more elegant solution today.

Allow people to temporarily (say, for 2-5 years) redirect all or part of their Medicare and Social Security payroll taxes - 15.3% (including the employer's contribution) of their gross pay - towards their mortgage payment. When the house is eventually sold, the money borrowed from Medicare and Social Security would be withheld (if it had not been paid back prematurely) and re-deposited into the individual's account (for use in later years, as intended.)

Republicans would like the idea because it is, in essence, a temporary tax break.

Democrats would like the idea because it would allow distressed homeowners to stay in their homes.

Both parties would like that they could say that they were doing something significant to resolve the current credit crisis.

The individual taxpayer would like it because those people who only purchased a house that they could actually afford would not have to, in essence, subsidize the people (via a direct government bailout) that bought more house than they could afford and the industry that permitted it (by offering inane things like mortgages with no-money-down and low teaser rates.) Instead, this solution would simply allow a person having problems meeting their mortgage payment to temporarily tap their Social Security and Medicare contributions (but not the money that had already been paid into the system.)

If necessary, the government could levy a tax on those borrowed funds so that people were motivated to pay the money back as soon as they could. The individual would have the option of paying the debt off prematurely (i.e. before actually selling their house) if they so wanted.

What if someone took advantage of this plan and later defaulted on the house anyways? The money that had been borrowed from their Social Security and Medicare accounts would be forfeit. I'd probably apply a penalty on top of that if that Social Security and Medicare money were not paid back. Thus, a bit of responsibility would be forced upon those people, but since the plan would only allow the Social Security and Medicare contributions from a couple of years or so to be utilized in this manner the impact wouldn't be that large.

To limit the ability of people that previously made bad decisions to compound their error, I would require that each homeowner be inspected to get a sense of how much help is needed. The decision as to how much assistance is warranted would be up to the inspector - not the homeowner. Thus, you would eliminate the possibility of people opting for the lowest-cost mortage now and then, once again, having problems paying back at some future date(s) all of the payroll taxes that they borrowed from themselves. Thus, some people would only need to tap a fraction of their payroll taxes to get by whereas some others might need something close to the total contribution temporarily redirected. The individual would never see that money - the mortgage payment would simply be lowered and the government would, in essence, be making the rest of the payment by taking the appropriate percentage out of the individual's Social Security and Medicare contributions.

Enacting this plan would immediately allow a huge number of people that are at risk of losing their homes to keep them. That would slow the supply of new houses going into the marketplace which would in turn help prices stabilize. Once housing prices stabilize, the massive uncertainty surrounding the value of mortgage products would begin to dissipate. Banks would have a far better sense of how much more capital they needed to raise in order to be able to cover their remaining writedowns and still meet federal requirements regarding their capital ratios, and investors would be willing to invest that money knowing that the bank wasn't nearly as likely as they have recently been to keep needing additional cash infusions (at ever lower prices, thus diluting the stake of earlier investors.) A housing recovery would therefore be accelerated and the chaos in the credit markets would subside.

One point to note is that money paid into the Medicare and Social Security funds don't actually just sit in a room waiting to be collected when someone reaches the appropriate age. The government takes that money and spends it now, leaving in essence an IOU in the piggy bank saying that they'll make good on the individual's retirement benefits - whatever those are, since they'll definitely change over the upcoming decades - when the time comes. Thus, allowing a contributor to access that capital now for something like a mortgage payment means that the government won't have access to that money. Thus, the government would in essence be running a larger deficit now (because you certainly won't see politicians curtail their spending by an equal amount) and therefore, in a sense, still bailing out the system. There is a huge difference, though, between this and what the government (under Treasury Secretary Hank Paulson, formerly CEO of Goldman Sachs) are pitching.

Paulson's plan is addressed at resolving the credit crisis by allowing the government to purchase the bad mortgages from the banks and therefore, as mentioned, allow them to raise more capital so that they can start lending again. The plan does nothing to address the plight of homeowners trapped in mortgages that they can't afford. As opposed to my plan, it therefore does nothing to diminish the number of houses that will keep flowing into the marketplace as those homeowners default (which will in turn cause housing prices to continue to decline.) His plan puts everyone's money at risk since the government will turn around and sell the $700 billion of mortages for whatever it can get, thus impacting all taxpayers regardless of their contribution to the current mess.

Additionally, with Paulson's plan the government would likely need to hold the mortgages considerably longer than it did in the late 1980s with the Resolution Trust Corporation (RTC) that is considered the closest equivalent to the Treasury's current proposal. That will be necessary because if it did not and simply dumped the mortgages at whatever price it could obtain then the banks would have to mark-to-market - another bad idea - their remaining loans with those firesale prices, thus cratering their balance sheet even more. The RTC also had a lot of good mortgages to sell (since it took its assets from failed banks that held a variety of mortgage types), whereas with this plan it would only hold the worst of the worst as it would be purchasing them from banks willing to sell them at whatever they could get.

My plan puts the risk and responsibility of a mortage back where it belongs - with the borrower and the holder of the mortage. By offering a way for far more homeowners to afford the houses in which they currently reside, my solution will keep more people in their houses and puts the responsibility of their failure squarely with them and the mortgage holder. The credit crisis is a symptom of the housing problem - not the actual disease. If more people can afford their current mortgages, then fewer houses will be foreclosed. If fewer houes are foreclosed upon then mortgage-backed securities will cease going down in price. If mortgage-backed securities stop going down in price, then banks will no longer have to keep writing off hundreds of billions of dollars. When that happens, investors will return on their own to inject new capital into the banking system, thus allowing lending to resume.

- TZ

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