Government policy is still backwards

The Obama administration is apparently ready to propose a massive plan to quickly address financial-sector weakness, along with less-aggressive efforts that might only moderately reduce foreclosures. If so, that would be like grooming a dog’s tail before you give the whole dog a flea bath.

More than four months after the Bush administration first proposed the $750 billion Troubled Asset Relief Program, the government still appears to be attacking the economy’s bad-loan problem from the wrong end.

The Obama administration will reportedly propose a bad bank to buy up some distressed assets and more Citigroup-type deals to limit banks’ losses on the rest of their toxic securities. In both cases, what we are talking about is potentially very large taxpayer subsidies.

But what will we get for these subsidies? Perhaps not very much in the way of additional lending as long as consumer confidence is sagging under too much debt and a foreclosure crisis that is dragging down home prices.

If we are going to be giving banks subsidies, at least we should make sure they are aimed directly at helping overburdened households to deleverage while bringing a quick end to the foreclosure crisis.

Here’s my proposal for doing just that:

First, the government should buy up a portion of mortgages up to roughly the foreclosure value of a home (say 40% of the purchase price) and provide homeowners with an ultra-low rate on this fully collateralized loan portion of 3% to 3.5%, interest-only for five years. I favor applying this program not just to distressed loans but to the estimated 50% of mortgages that are unable to refinance because of insufficient equity.

For this outlay, the government can provide an immediate boost to household cash-flow, while gaining maximum leverage as senior debt holder to bring about the most constructive outcome when loans go bad, including renting to the current resident.

Next, rather than a direct subsidy that benefits only bank shareholders, the government would provide incentives for matching principal reduction. Importantly, the incentives would only apply for a short time, and they would be less generous for loans that are already in default. No other approach will do as much to bring about proactive principal reduction, while spreading the cost between private investors and the government.

For loans in default, the government could offer to match dollar-for-dollar all first-lien principal reduced and the first $20,000 of second-lien principal. For every $2 reduction in second-lien principal beyond $20,000, the government could match with $1.

For loans that are current, the government could cover two-thirds of principal reduction on first liens and the first $20,000 of second liens, and 50% of additional second-lien principal.

Essentially, this would give mortgage investors a narrow window of opportunity to hedge their bets and cut future losses on loans that may well be unsustainable in this economic climate. And the government would reward this proactive approach by taking on a sizable portion of losses.

Further, both private investors and the government would be rewarded with tradable warrants to benefit from future home-price appreciation enjoyed by the universe of homeowners bailed out through principal reduction.

The government’s ability to gain the leverage to end foreclosures by taking over home loans up to their foreclosure value would require mortgage investors to subordinate the remaining private portion of the first lien to the government portion. But this is a legal change that all mortgage investors should be willing to accept because it will include a low interest rate and no principal payments for five years to help make a loan sustainable, an opportunity for matching government principal reductions, and a legislated commitment by the government to act as advocate not just for the homeowner but also the investor.

Obama’s economic team does plan to ramp up efforts to reduce foreclosures in comparison to the Bush administration’s modest efforts. But as I argued more fully in an RGE Monitor piece last month (http://www.rgemonitor.com/financemarkets-monitor/255111/the_best_and_surest_way_to_end_foreclosures ), the policy options that have been discussed fall well short of the forceful and proactive measures that are needed.

While much is unknown about the Obama team will attack the foreclosure problem, the efforts are expected to involve bankruptcy cram-downs and the FDIC loan-guarantee plans, which would only apply to households as they become distressed and either file for bankruptcy protection or fall 60 days behind on their mortgage.

Both approaches could still result in foreclosure, even after a judge has crammed down principal or a lender has modified loan terms to qualify for the government’s guarantee of up to 50% of loan losses. Indeed, the FDIC plan would make foreclosure a more rewarding option for lenders than it is without such a guarantee. What is more, the FDIC plan, which prioritizes rate reductions and loan extensions over principal reduction, could leave homeowners stuck with a mortgage far in excess of a home’s underlying value.

While banks are certain to need more capital even after a bold push to end the foreclosure crisis, the lesson of the past four months is that the cost of shoring up bank balance sheets will keep spiraling unless we promptly address the economy’s underlying weakness. The longer it takes for our foreclosure crisis to end, and the longer it takes for homeowners to work off excess debt, the longer it will take for our economy to find a floor and begin to recover. This proposal offers a way of stepping on the gas.

Jed Graham writes about economic policy for Investor’s Business Daily, but the views expressed here don’t reflect the position of IBD.