The Real Cost of the Geithner Plan

Treasury Secretary Timothy Geithner’s toxic asset plan is a brilliant, highly complex and very expensive answer to the wrong question: How we can raise the value of bank portfolios without improving the quality of the underlying loans?

 

It is truly remarkable that an administration that preaches progressive economics intends to deploy $1 trillion – including hard-to-value but nevertheless very pricey subsidies – to help banks in a way that avoids helping their existing borrowers.

 

Of even greater concern is the relatively weak economic thrust of a plan that will take many months to implement and – if successful – may only marginally increase lending because the pool of potential creditworthy borrowers is shrinking as the economy deflates.

 

The biggest cost of the Geithner plan may be the missed opportunity to deploy these resources in a way that gets at the heart of one of our economy’s central problems – an excess of mortgage debt based on now-fanciful home values.

 

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.

 

In contrast to the Geithner plan, devoting these resources and subsidies to facilitate a restructuring of the debts of under-water borrowers and those merely treading water could provide an immediate and lasting boost to household cash flow and confidence.

 

Consider two scenarios. In the first, the Geithner plan pays 50 for mortgage securities now priced at 40, arguably providing a 25% subsidy to banks equivalent to $200 billion of the $1 trillion dispensed.

 

In the second scenario, lenders reduce mortgage principal by $200 billion to qualify for matching reductions pledged by the government to spur a proactive restructuring of mortgage debt.

 

The second approach reduces outstanding mortgage debt by $400 billion and substantially stems the tide of foreclosures for the same price as the first that does nothing to reduce principal or limit foreclosures.

 

Is there really any question as to which approach would do more to help the economy?

The administration could argue that the toxic political environment makes it difficult to provide more help for borrowers, but I think they have both the politics and the economics wrong.

 

Surely, most Democrats are more interested in helping over-indebted borrowers than undercapitalized banks. And Republicans, as part of their stimulus alternatives, pushed a measure that would provide refinancing to under-water homeowners.

 

While the populist mood makes it logical to help banks by helping their borrowers – and the economy – it does suggest the need for policies that reach broadly instead of merely helping the most distressed.

 

Some advocates of bank nationalization, such as New York Times columnist and Nobel-prize winning economist Paul Krugman, insist that nationalization is the logical alternative to Geithner’s plan. But unless nationalization advocates believe that much of our banking sector is insolvent – as opposed to one or two too-big-to-fail banks – then their high-profile advocacy is mostly serving to distract focus from our key economic imperative: a broad and proactive restructuring of the excess of private debt that continues to drag down the economy.

 

There may be various ways of accomplishing this goal, but below is my suggestion for ending the foreclosure crisis that I first wrote about for RGE Monitor in November.

 

First, the government should buy up a portion of mortgages up to roughly the foreclosure value of a home (say 35% to 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 mortgages that are unable to refinance at current low rates 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. Remaining private lien-holders would now have no incentive to foreclose and every incentive to make loans sustainable.

 

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 should 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.

 

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.

 

While fairness is in the eye of the beholder, I think this proposal comes closest.

All homeowners with mortgages could benefit from refinancing, either through this program or the opportunity provided by Fed-induced low mortgage rates.  Additional help is directed to those who most need it, but they have to give up a share of future home-price appreciation.

 

The final piece of a fair and comprehensive solution is to provide generous tax credits for home purchases to sop up excess supply, thus rewarding renters who have made sound economic decisions. A sensible approach would be to start with a 5% tax credit (up to $25,000) on home purchases. This tax credit could steadily phase out over 15 months, helping to rebalance supply and demand while cushioning the landing in home prices.

 

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

8 Responses to "The Real Cost of the Geithner Plan"

  1. Anonymous   March 30, 2009 at 8:44 pm

    Here’s a third approach:1) Everybody pays their own mortgage2) Those who can’t pay, or don’t feel like paying their own mortgage can rent.3) Banks and speculators who lent money to people who can’t pay, or don’t feel like paying their mortgages, can foreclose, eat their losses, and lick their wounds. They will be replaced by wiser speculators, and better-run banks.This approach has the advantage of not placing the burden of losers’ losses on the honest, prudent majority of Americans.

    • Mitty   April 1, 2009 at 11:25 am

      Thanks for being first in line Anonymous, because you got it right. No need to read beyond your post.Government policy concentrated too much of our economy into housing & finance creating massive bubbles. Now, the government needs to stand aside and let entrepreneurs create a better balanced, market-driven economy.Further government tinkering will only exacerbate the problem, create new ones, & prolong the inevitable.

  2. Guest   March 30, 2009 at 8:48 pm

    What is in it for the home owner who does not have a mortgage? Do I get a tax increase to help pay for this deal? I wish some one would answer this!!!!!!Since the Fed does not seem to care about debt what about doing away with all real estate taxes? Have the Fed reimburse the local government for loss revenue. This would free up in most cases over 300 (in some states real estate taxes can run up to $10,000 on medium size homes) dollars in mortgage payments per month plus people with our mortgages would have extra money

    • Rcoutme   April 3, 2009 at 7:47 am

      The only incentive you get? Hah! You get no incentive. The problem with the entire system is the belief that those in need trump the rights of those not in need. Until we get over that, there is no solution.

  3. Anonymous   March 30, 2009 at 10:49 pm

    Guest, you most certainly will get a tax increase to pay for this largesse. Either that, or our pandering politicians will spend the next generation into the Stone Age trying to re-inflate the ridiculous real estate bubble.

  4. Guest   March 31, 2009 at 10:01 am

    Could this approach be integrated with the plan outlined by D’Arista to incentivize lending by shifting Fed repos to the liability side of both Fed & institutions?

  5. Anonymous   April 1, 2009 at 8:19 am

    “It is truly remarkable that an administration that preaches progressive economics intends to deploy $1 trillion… to help banks in a way that avoids helping their existing borrowers.”It is even more truly remarkable that the millions of us who acted responsibly with our money are being sacrificed by government and pundits alike, on the premise that we must pay to avoid economic armageddon. Guess what, the sheep are starting to stir.

  6. Hootsbuddy   April 4, 2009 at 7:48 am

    Last year I heard a wide ranging interview with Elizabeth Warren which mentioned, among other topics, the problem of loan servicers. My recollection of her explanation is that once closed, loans are sold in an aftermarket which subsequently slices and dices them for repackaging and bundling in the form of the now famous toxic assets. Between the origination and the sale of those “securitized debts” (Is that an oxymoron?) is the low-profile business of “processing.”Under normal conditions the job of servicing is time-consuming but straightforward. In fact, when a loan defaults the servicers make more because their job is done.But problems at the origination end of the process are very time-consuming to trace backward through the system. It’s like unthreading woofs and warps in a textile mill then running new threads where the old ones are removed, all the while trying not to stop the loom.Consequently servicers faced with that task becomes some greater multiple of time-consuming than before. The problem is that processors are paid at the originating end. In the case of foreclosures the costs of paying processors to track mortgages backward up the food chain simply adds to the already mounting losses.With no compelling (i.e. legally enforceable) reason for servicers to do this totally essential job, the stimulus bill includes funds to “bribe” that business to follow up on the tedious but necessary job of replacing all those missing strings on the loom.Unless and until that task is done, a toxin remains in the toxic asset.What am I missing?=================As I was putting together the comment, I found the interview and listened to it again. It is now in an updated form and was rebroadcast last month, but I recognized the content from the program I heard last year.http://www.npr.org/templates/story/story.php?storyId=101611260