EconoMonitor

Dan Alpert's Two Cents

The Freedom Recovery Plan for Distressed Borrowers and Impaired Lenders

Overview

With the passage of the Emergency Economic Stabilization Act of 2008 (“EESA”), the twin housing and mortgage crises have now forced the government to directly battle, with massive financial intervention, the systemic implications for our banking (and shadow-banking) institutions. Notwithstanding the magnitude of government support that EESA will bring to the resolution of the credit and banking crises, the financial and social implications arising from the housing bubble, for homeowners and the broader economy, require the consideration of additional unconventional solutions that are not inconsistent with the rubric of our system of laws and property rights. Such solutions must also place less reliance on direct intervention from a heavily extended government (and its taxpayers). The Freedom Recovery Plan (the “Plan”) is a structured package of government and private-sector measures that amount to a national “workout” of the residential real estate elements of the overall crisis in the capital markets. The housing sector’s ongoing meltdown presents unique challenges that were not front and center in prior boom and bust cycles. Accordingly, special actions are necessary to limit the damage to vast population segments and the knock-on effects of such damage to our normally resilient financial sector and economy. That such actions should endeavor to maximize the role of the private sector should be self-evident to those with lingering concerns about the total costs to which the government has already committed.

The Plan is designed to promote accelerated settlement, between borrower and lender, of impaired mortgages (as such impairment is described below). Settlements under the Plan would involve homeowner/borrowers, with impaired mortgage loans, voluntarily surrendering the deeds to their homes to their mortgagees in consideration of the right of continued occupancy, as tenants, for a period of five years. The Plan would provide cost savings and incentives to both borrower and lender, as detailed below, so as to encourage them to settle without going through the very costly proceedings of foreclosure or bankruptcy. The federal government, in addition to providing certain tax incentives, would compel lender compliance with the Plan.

The Plan has been formulated to adhere to five basic principles that:

(a) cause parties that took unwise risks to also take responsibility for their acts (i.e., no exacerbation of moral hazard; we’ve had enough of that with EESA’s passage);

(b) rely as little as possible on the government/taxpayers;

(c) strive to keep people in their homes;

(d) save lenders and borrowers the enormous costs of adversarial foreclosures;

(e) provide sufficient time for American families who are unable to afford continuing homeownership to work their way out of their mountain of debt and rebuild material savings.

Unlike other voluntary solutions to the current housing correction, proposed or enacted to date, it is “as of right” from the homeowner’s standpoint; the lender must accept deed surrender from a home with a qualifying impaired mortgage, without penalty, subject to the Plan’s considerations and requirements. While this requirement may be somewhat controversial from the standpoint of property and contract law, it is substantially more legally benign than some recently advanced suggestions to grant courts the right to summarily reduce mortgage balances and interest rates on legally made and secured mortgage loans. In contrast, the Plan offers a complete workout solution that is equitable to the borrower and permits the lender to efficiently realize the full market value of its loan collateral. We are concerned that if performance in accordance with the Plan is not mandatory, lenders will continue to be resistant to realistic settlements – as has been the case under the several voluntary solutions promulgated to date.

The Origin of the Crisis, in Unprecedented Debt Creation, Requires a Bespoke Solution

The problem that has overcome the economy has its most recent roots in the creation of nearly $7 trillion of new residential real estate and consumer debt during the first six years of this decade. Much of this debt was created between 2004 and 2006, when U.S. savings rates turned negative. Simply put, this level of debt creation was unprecedented, more than doubling homeowner and consumer debt (credit cards and auto loans, for the most part) that existed at the end of 1999. The extension of this mountain of debt was enabled by a prolonged period during which the Federal Reserve Bank maintained its target Fed Funds rate at or below the rate of inflation, thus essentially providing a subsidy to borrowers (banks that borrowed from the Fed, and the institutions and individuals to which the Fed Funds were re-lent) and a massive incentive to borrow. The Fed’s policy went well beyond offsetting the shock to the economy that followed the 2000 crash of the technology stock bubble and the horrific impact of 9/11; it also engineered a new, and quite dangerous, asset inflation bubble in residential real estate, as well as in the value of businesses and commercial real estate assets acquired with billions of dollars of leveraged acquisition loans. Finally, lax and irresponsible lending standards and underwriting criteria in the mortgage-lending and mortgage-backed securities industries eliminated virtually all credit-oriented constraints on lending, resulting in a total suspension of disbelief in continuingly rising home prices and the decoupling of homes’ carrying costs from those of renting equivalent properties, all set against a backdrop of countervailing trends in personal incomes.

That the ready availability of trillions of dollars of cheaply priced, loosely originated loans pushed residential real estate prices to unjustifiable levels is now generally appreciated. The magnitude of the problem, its ultimate impact on our economy and society, and what can actually be done by government and the private sector to put this behind us as swiftly as possible, were, until last month, drowned out by a combination of blind optimists and well-meaning politicians who have suggested solutions that have proven to be either nonstarters or wholly inadequate. As with the debate, passage and enactment of EESA, the present situation demands a thorough understanding of what has transpired, the threats posed to our economy and financial security, and a path to resolution that can be employed with great dispatch—one that reduces the burden on the country’s general common wealth (the ordinary citizen and taxpayer). In fact, as the Plan promotes and accelerates resolution and settlement of impaired loans, it should reduce the government and U.S. taxpayer exposure that arises from bank intervention and recapitalization actions being taken under EESA, as set forth below.

To resolve the U.S. housing crisis, it’s critical for home prices to return from their bubble-era levels to one that is consistent with pre-bubble historical ratios of housing prices to comparable rents and of median home prices to median incomes. The supply of homes available for sale and demand for them can achieve sustainable equilibrium (relative to available inventories) only at prices that reflect reasonable rent and income multiples.[1] There is, however, a material risk that home prices will considerably overshoot the mark of parity with rent- and income-driven values, if wave after wave of foreclosures continue to swell for-sale inventories. We are already seeing signs of this in some badly affected markets. Furthermore, continuing foreclosures will place additional financial and societal strains on the economy: The cost of adversarial foreclosure has grown to more than 25%, on average, of outstanding loan balances, and the displacement of families affected by foreclosure engenders its own economic and social strains. The Plan is designed to dramatically reduce the need for adversarial foreclosure and to eliminate, in the case of qualifying mortgages, the displacement of households and the addition of new inventory to the for-sale backlog.

Plan Elements

The Freedom Recovery Plan for Distressed Borrowers and Impaired Lenders will encourage homeowners to seek out and settle with their mortgagees, without fear of being immediately dispossessed of occupancy. It is designed, among other provisions, to give borrowers an opportunity to reverse the debilitating practices of dis-saving and over-consumption, as well as afford distressed homeowners a period within which to rebuild their financial lives and, ideally, redeem their homes.

At the heart of the Plan is the “Recovery Lease”: a fixed-term (5-year) right of occupancy lease that will have certain unique features to benefit both landlord (the former lender, or a subsequent assignee of title to the home and the Recovery Lease) and tenant (the former homeowner, with no right of assignment or sublease). The Recovery Lease is the result of a settlement under the Plan, in which the lender becomes the sole owner of the home, while granting the borrower the right to retain home occupancy for the Recovery Lease’s duration (with no right of renewal), as well as the right to reacquire the home, at the lease’s end, at its then-fair market value (i.e., the price a third party would pay at the time). Underlying the notion of the Recovery Lease is a practical consideration: As many homeowners invested little to no equity when purchasing their homes—or, during the bubble, refinancing their homes to the point of eliminating all equity—the borrower has been a “homeowner” in name only. There is therefore no benefit to continued ownership under such circumstances (and, conversely, there are continuing and material risks to any lender maintaining a loan to any such disenfranchised and disinterested borrower).

We expect that a combination of steady rental income, tax benefits and the potential for capital gains on the resale of the homes to former homeowners or third parties (at the expiration of the Recovery Leases) will result in an active market for debt and equity investment in Recovery-Leased property in the short to medium term.

The principal Plan elements, and the legislation required to enact them, would be as follows:

I. Eligibility – Mortgage loans eligible for settlement under the Plan must involve some version of demonstrable impairment (a “Qualified Impaired Mortgage,” or “QIM”). The eligibility requirements’ intent is to eliminate, from the Plan’s mandatory settlement requirements, mortgage loans that are in default merely because of homeowner unwillingness to make payments, or are otherwise restructureable through ordinary nonmandatory, arms-length negotiation between lender and borrower.

Accordingly, to be considered a QIM, a mortgage loan must satisfy one or more of the following tests:

a. It must satisfy both of the following criteria:

i. Have a prevailing accruing interest rate higher than [10]%;

ii. Have an outstanding principal balance higher than 90% of the value of the underlying home at the time of the settlement.

OR:

b. It must satisfy both of the following criteria:

i. Have an outstanding principal balance that is equal to, or higher than, 110% of the value of the underlying home at the time of the settlement;

ii. Either:

1. the borrower can demonstrate and certify (under penalties of perjury) that the total of mortgage debt service, real estate taxes and homeowner’s insurance costs relating to the home constitute more than 40% of the homeowner’s normalized family gross income; or

2. the borrower can demonstrate and certify (under penalties of perjury) that the borrower or the borrower’s spouse/partner has lost his or her job, suffered a disabling medical condition, suffered the death of a spouse/partner, or has been divorced from and abandoned by a former spouse/partner—in all cases, after the mortgage loan was originally made.

OR:

c. The mortgage lender has issued to the borrower/homeowner a notice of default and intent to foreclose, and has commenced court proceedings for foreclosure.

Notwithstanding the foregoing, mortgage loans will not automatically qualify as QIMs (x) if it can be demonstrated that a borrower made a material misrepresentation on his loan application, (y) if the property securing the mortgage is not the borrower’s primary residence; or (z) if at least three monthly payments were not received on the loan since its origination (i.e., the borrower does not have a history of making concerted efforts to pay).

Any mortgage loan satisfying the criteria in a, b or c, above, shall be a QIM and shall give the borrower the right to participate in a settlement under the Plan, with the lender mandated to effectuate such settlement on the borrower’s request. Notwithstanding the foregoing, a settlement under the Plan shall be available to all borrowers and lenders, by mutual agreement, regardless of whether the above criteria are satisfied.

II. Surrender of Deeds and Settlement of Mortgage Loan Obligations – Lenders will take title to homes settled under the Plan. The lender will release the borrower from any and all obligations associated with the former loan and will take title as-is and without recourse to the former borrower. No interest, penalties or fees may be assessed by the lender in connection with the settlement. Lender and borrower shall mutually release each other from any preexisting claims or threatened claims at the time of the settlement. The only continuing relationship between lender and borrower shall be set forth in the Recovery Lease pertaining to the subject home. Trustees and mortgage servicers of mortgage securitizations will be required to comply with the Plan’s mandated settlement requirements, and the enacting legislation will contain a presumption that compliance with the Plan constitutes acting in the best interests of, and to maximize value for, holders of mortgage securities, and that legal challenges to Plan compliance on the part of trustees and servicers shall be barred as a matter of public policy.

III. The Recovery Lease – Homeowners voluntarily surrendering the title to homes securing QIMs (or by mutual agreement between lender and borrower in the case of mortgage loans that are not QIMs) will be entitled to enter into Recovery Leases that provide for continued occupancy by the former homeowner. Recovery Leases will feature, among other provisions, the following terms and conditions:

Term: Five years from the date of settlement with the lender. No rights of renewal or extension, even by mutual agreement of the parties. Any renewals or extensions subsequently agreed to will not enjoy the special protections and features of a Recovery Lease.

Rent: Recovery Lease rents will be set at the level of comparable rents for the state, city and submarkets in which the leased property is located, with due respect given to the quality of the home. Critical to the Plan is the fact that the rental cost of homes in most markets is often significantly lower than the total carry costs of owning a home.[2] Therefore, setting rents and prevailing levels will generally result in significant relief to former homeowners in terms of monthly housing costs. The Department of Housing and Urban Development, along with the housing departments of each state, will, for the duration of the housing emergency, empanel Rent Review Boards that shall be responsible for developing and maintaining rent matrices by zip code. For each (five-digit) zip code, an average per-square-foot rent level for each of four quality levels of homes (low, medium, high and luxury) will be established and revised annually. These average rents are not meant to control them; rather, they are meant to provide a guideline that reflects a market appraisal of rents in the open market. Recovery Lease Rents shall be mandated to be appropriate for the market and home quality of a Recovery Leased property, but in all events may not exceed 110% of the average market rents established and published by the Rent Review Boards (the “Maximum Rent”). A lower rent may result from arms-length negotiation between the former lender and the former homeowner. Rents may increase biannually under Recovery Leases, but in no event be higher than the prevailing Maximum Rent. The Rent Review Boards—or local sub-panels—will hear appeals from any tenant disputing a landlord’s compliance with the rent limitations and will be empowered to mandate resetting of rents. All rents shall be “gross rents,” with the landlord bearing all real estate taxes, insurance premiums and maintenance expenses relating to the home. Utilities shall be borne by the parties to the Recovery Lease in accordance with local custom and practice.

Transferability: The Recovery Lease shall not be transferable from the tenant to any other lessee or sublesee. The tenant must remain in occupancy of the property. The property and the Recovery Lease, however, are to be fully transferable by the former lender/landlord to any other party, subject to existence of the Recovery Lease. It is an express objective of the Plan that former lenders be encouraged to dispose of Recovery Leased homes to real estate investors in an orderly manner, and certain tax benefits are to accrue to investors in Recovery Leased homes, as set forth below, to maximize the value of such Recovery Leased property (based on its value as a rental property investment).

Right of First Offer: 180 days prior to the expiration of the Recovery Lease, the tenant (former homeowner) shall have the exclusive right to acquire the home at the then-fair market value (determined by appraisal in absence of an agreement between landlord and tenant). In the event the tenant fails to acquire the home prior to the expiration of the Recovery Lease, there shall be no further obligation of landlord to tenant, and the home can either be sold to a different buyer, free and clear, or leased to any tenant, with a rent determined at the landlord’s sole discretion.

Termination: In the event the now-renting former homeowner is in arrears on rent for more than 30 days, he/she would be subject to eviction, as in the case of any lease.

Sunset: Recovery Lease arrangements shall have a well-defined sunset, and the Plan shall permit Recovery Lease arrangements to be entered into for a period ending 18–24 months from the passage of enabling legislation. The purpose of this provision is to accelerate settlements into the shortest possible period so as to rapidly and aggressively move to stabilize the housing market.

IV. Tax Law Modifications – To provide incentives to both lenders and homeowners to enter into settlements pursuant to the Plan, Congress shall enact legislation pursuant to which the following modifications shall be made to existing tax law:

a. A new section of the Internal Revenue Code (“IRC”) shall be enacted to provide that lesees under Recovery Leases (former homeowners) shall be entitled to deduct from their ordinary income the rent paid on Recovery Leases. This provision is not intended to reverse the IRC Section 163(h)—the mortgage interest deduction—but is meant to level the playing field in connection with the former homeowner’s transition from homeowner to tenant. This provision will be revenue-neutral (or possibly revenue-enhancing) to the U.S. Treasury, inasmuch as the former homeowner was previously permitted to deduct all mortgage interest payable on his preexisting loan (whose interest payment is likely to have been greater than the rent payment under the Recovery Lease).

b. The provisions of IRC Section 469, limiting losses from passive activity such as rental housing from offsetting ordinary income, shall be suspended in connection with the ownership of homes subject to Recovery Leases. Upon expiration or termination of a Recovery Lease for a property, further leasing activity in respect of such property will once again be governed in accordance with the existing provisions of IRC Section 469. While not necessarily revenue-neutral, the purpose of this provision is to enhance lenders’ ability to expeditiously sell Recovery-Leased property to third-party, noninstitutional investors.

c. The provisions of IRC Section 1250 shall be amended to provide that homes leased pursuant to Recovery Leases may be depreciated over the following periods, in contrast to present depreciation allowances:

i. Rental property structural improvements (buildings) to be depreciated on a 17-year “double-declining” basis, as opposed to the 27.5-year straight-line basis currently permitted;

ii. Appliances and other nonreal property within Recovery-Leased homes to be depreciated over a 5-year “double-declining” basis, as opposed to the 5-year straight-line basis currently permitted;

iii. Landscaping and pavement on the site of Recovery-Leased homes to be depreciated on a 10-year “double-declining” basis, as opposed to the 15-year straight-line basis currently permitted.

While not revenue-neutral, this provision is intended to enhance lenders’ ability to expeditiously sell Recovery-Leased property to third-party investors. Depreciation periods for homes subject to Recovery Leases shall revert to current schedules at the termination or expiration of the Recovery Lease with respect thereto.

V. Regulatory Provisions – Banking, insurance and other regulated lenders will be required to mark loans settled under the Plan to the market values of the homes they have taken pursuant to the settlement. Lenders will be motivated to monetize homes subject to Recovery Leases as soon as possible to get the assets off their balance sheets in exchange for cash to improve regulatory capital. Nevertheless, Federal and State legislation should be promulgated to permit institutions to hold homes subject to Recovery Leases as “real estate held for investment,” rather than “real estate owned.”

VI. Other Government Agencies – It is expected that a combination of steady rental income,tax benefits and the potential for capital gains on the resale of the homes to the former homeowner or third parties (at the expiration of the Recovery Leases) will result in an active market for debt and equity investment in Recovery-Leased property in the short to medium term. Nevertheless, the enabling legislation promulgating the Plan should direct Fannie Mae and Freddie Mac to institute a favorably priced program to purchase and/or guarantee loans of up to 80% of the value of Recovery-Leased properties to qualified investors therein.

Conclusion

The housing bubble, and the contemporaneous overextension of $7 trillion of new credit to the consumer and householder earlier this decade, has placed unprecedented strain on the vast U.S. middle class. Incomes during the decade have declined in real terms, and certain costs of everyday life—healthcare, education and energy—have increased materially.

This decade’s financial and economic tale includes two other factors that require emergency actions in the nature of the Plan:

(i) a decline in net savings rates for the American middle class below zero (slightly below zero for the country as a whole, more so for the middle class)—meaning that U.S. citizens are, on average, dis-saving by going increasingly into debt: and

(ii) the substantial likelihood that more than $5–$6 trillion of home value (25% to 30% of the $20 trillion of aggregate home value at the peak of the bubble) will be eradicated as a result of the collapse in home prices—representing a devastating collapse of wealth in many U.S. markets, to say nothing of making millions of homes worth less than the mortgage loans outstanding against them.

While financial institutions can be rescued with capital infusions that allow credit to slowly be made available again, American families and their homes will require the benefit of considerable amounts of time to right themselves. Consumption must slow, along with reliance on credit, and savings and net worth must be painstakingly rebuilt. Homes will be revalued to the point of historical comparisons to rents and incomes, but such revaluation inherently runs the risk (actually, a certainty) of substantial disruption to the lives of families, if not their financial ruin, with the pendulum swinging considerably past the point of re-stabilization of home values and into the meltdown zone.

The Freedom Recovery Plan is designed to ease America’s 75+ million homeowners through the economic devastation, keep them in their homes and minimize the burden on general taxpayers, which would result from a wholesale “bailout” of all homeowners and lenders. At its core, the Plan fosters what the markets will force upon the residential real estate industry and mortgage lenders. In the absence of such an impact-buffering protocol, families, financial institutions and the U.S. government will suffer even greater pain and take longer to rebuild and move forward.


[1] Note that price-to-rent multiples remained in a band of 14x and 16x for decades prior to the current one. At the housing bubble’s peak, price-to-rent multiples ballooned to more than 26x.

[2] Mortgage debt service plus the costs of real estate taxes, insurance, and maintenance (and, in some markets, certain utilities) commonly borne by landlords.

5 Responses to “The Freedom Recovery Plan for Distressed Borrowers and Impaired Lenders”

AnonymousOctober 19th, 2008 at 9:57 am

Thank you Mr Alpert for the excellent article outlining in considerable (yet very understandable) detail your plan for addressing the multiple aspects (homeowner/community side, financial industry side, governmental/regulatory/IRS side) of the housing collapse.The “overview” and “origin of the crisis” sections are succinct and effective in establishing the undercurrents which have brought us to this disaster.The detail in which you have described the elements of the Freedom Recovery plan is very impressive.I share your belief that a well defined and consistent federal plan that equitably distributes the burden of working through the credit bubble is superior to using the courts to re-adjust mortgages.Have you distributed your plan yet beyond the RGE Monitor community? Is it acceptable to you for readers to forward this article to our representatives in D.C, state government reps and to news outlets?Thanks again for making your ideas available to us and thanks to Dr Roubini for the RGE Monitor. The quality of the information on this site gives me hope that we will have the good fortune to avoid a complete financial collapse.

GuestOctober 20th, 2008 at 2:27 pm

US Real Estate in Bargain Territory!!Brand New Homes in Postcard City LAS VEGAS with Builder Warrantees at AUCTION.Min Bids $99,000.All Bidding will take place ONLINE.The homes are available for viewing now and thru the bid deadline NOV 6th.See http://www.FRE.com/295Z1 for more details…

GuestOctober 20th, 2008 at 3:52 pm

This is by far the most intelligent plan yet proposed. As the owner of an expensive home with a mortgage of much less than 50% loan-to-value, even at current prices, I am very disturbed at seeing my equity evaporating daily. The government needs to do something that will also help owners like myself, who have never been late with a payment. I think that, in addition to the Alpert plan, the government should adopt the Australian example of giving a first-time buyer a tax credit to stimulate some demand. Until buyers see a bottom, there will be no incentive to purchase, and this downward cascade will continue.A Miami Homeowner

Rob FredericksOctober 21st, 2008 at 7:57 pm

American Homeowner Preservation has a program which shares some elements of The Freedon Recovery Plan: see http://www.ahpoh.org.AHP purchases the homes on a short sale at substantially less than current appraisal and allows the homeowner to remain in the home as a tenant with an option to repurchase at any time between years 3 – 10 at a price equal to AHP’s purchase price plus 15% plus the cost of repairs. For instance, if a home was purchased for $150,000 two years ago with 100% financing, and the value has now dropped to $120,000, then AHP will purchase for $80,000 and the homeowner will have the option to repurchase for $92,000.AHP is funded with tax-exempt bonds issued by local municipalities. Summit County Port Authority issued $12,500,000 in bonds on September 15 to fund the pilot program. Within the month, over 200 Ohio families have applied to participate.Innovative solutions such as American Homeowner Preservation and the Freedom Recovery Plan should be embraced by lenders, politicians, and homeowners alike as tools to prevent foreclosures and preserve neighborhoods.

Maurice GarveyOctober 21st, 2008 at 11:05 pm

http://my.barackobama.com/page/community/post/mauricegarvey/gGgHshCommunity Blogs Login | Register | Search BlogsPost from maurice garvey’s Blog:Barak Obama’s policy response to John McCain’s housing plan.By Maurice from Villa Park, IL – Oct 14th, 2008 at 6:46 am EDTBarak Obama’s policy response to John McCain’s housing plan.He could have said,Mr. McCain, we must remember that a root of our housing crisis is twofold. First, some people cannot make their mortgage payments. Second, banks no longer receiving those payments must cover those losses with money that cannot be loaned to other borrowers. These two facts have revealed a sick and broken relationship between borrowers and lenders by causing a spiral of declining home values and a credit contraction (an inability to get loans) that is affecting the average person’s sense of security for family, retirement, and working life.It is true that some people’s dreams were certainly larger than the reality of their pocket books. It is true that some banks made risky loans beyond many borrowers ability to repay. It is true that our present crisis is revealing that enticements such as no money down, no fees, no income verification, and high debt to equity ratios were evidence of a system breaking down. These borrower/lender problems, masked by years of quickly rising housing prices, could be ignored only as long as the house could be sold at ever increasing prices. The real cause of the crisis is the acceptance of ‘poor equity and high risk’ by both sides of the borrower/lender relationship. Equity is the tangible evidence of the borrower’s real interest in the present property. Put simply, equity is what the borrower really puts into the property. Poor equity reveals that, at present, there is little or no real interest in the property and that any real interest in the present property is only imagined as equity projected into the future as something the owner might have later.What is revealing itself right now is that the financial crisis has infected more than just the housing markets: it is probably in all sectors of the economy to varying degrees. It is signaling that the world wide system of money circulation is damaged. While we in the United States have overextended ourselves as borrowers by importing vast amounts of the world’s goods it could not have happened so easily without others financing our debt by loaning us the money to buy their exports. Money, at home and around the world, is no longer flowing so freely from one place, or person, to another because lenders are simply afraid that they have a smaller chance of being paid back tomorrow on money they could loan today. No matter a person’s, or a country’s, credit score or down payment, it is getting harder to find money to borrow to get a car, a student loan, or a house. The credit score needed, the collateral needed and/or the interest cost of borrowing money may need to go very high during the process of reestablishing a healthy relationship between lenders and borrowers.We must remember that the real cause of the financial crisis is the acceptance of ‘poor equity and high risk’ by both sides of the borrower/lender relationship. Before spreading, this crisis first showed its ugly head in the housing markets here at home. To begin solving our problems we must first work at restoring a healthy borrower/lender relationship that begins with housing. This is not an easy thing when it is hard to judge the real value of a house in an unstable real estate market. The problem is in finding a way to stabilize declining house values. During the time that takes, more people could lose their homes through foreclosure. Vacant homes depress prices further as they continue adding to the supply of available homes on the market. Rising interest rates would also depress home prices as the cost of borrowing increases. Additionally, there is a growing percentage of borrowers that have a great negative equity in their home; and, if or when it becomes evident that the home will not regain its former value it will make financial sense for many of these borrowers to abandon their property by leaving it to the lenders.The revolting aspect of just buying these bad loans to take them off the balance sheets of banks is that it does nothing for the troubled borrower or for any other person experiencing their housing value decline. Interest only loans in the hope that housing prices will again increase makes no sense except as a crap shoot. A person owning a house that they cannot afford to live in because of a high debt to equity ratio makes no sense. Continuing mortgage payments on a house that was grossly overvalued makes little sense in the long run. A borrower who has no ability to increase equity in the property has no reason to keep it up. Keeping people in a home in which they have an established and growing equity is the only way to begin to reestablish the healthy relationship between lender and borrower. It must be in the interest, as well as the ability, of the borrower to keep making payments that grow equity; and, it must be in the interest of the lender that the borrower be interested in growing property equity so that the lender has the long term ability to recycle the money loaned.One way (and it is vital that we come up with other ways) for lenders to encourage troubled borrowers to stay in homes declining in value is to set up a five year program where the lender offers a ‘rent to own’ alternative. Market rents for any neighborhood are still relatively stable and easy to determine. Instead of conventional mortgage payments, offer payments of market rent plus ten percent; of which, that ten percent is to be held in an ‘equity down payment’ escrow account for the borrower. This ‘equity down payment’ account will begin working on the borrowers equity side of the problem and by encouraging people to stay in their homes the lenders assets begin performing again. At any time after participating in the program for at least one year, and prior to the ending of the program in five years, the borrower may repurchase the home at a new fair market price by adding to the ‘equity down payment’ escrow an amount of money at least equal to ten percent of that new market price. During this program, if the borrower wishes to move then the ‘equity down payment’ money moves with them and can be used for the purchase of any other home. With both borrower and lender participation in this program we can: first, begin using rental income as a basis for stabilizing housing values for lenders by keeping their assets performing; second, begin growing equity as a real foundation supporting housing values for borrowers; and third, in conjunction with one and two, the real problem of cultivating healthy relationships between borrowers and lenders is begun. The program is simply encouraging the development of a qualified borrower for a serviceable loan from a lender. Is this simply too good to be true? Not at all! In fact it is the only sane way to do it. Right now, we are coping with the aftermath of our insane lending and borrowing practices. Until we begin to change our poor habits, which are grounded in our unhealthy expectations, money will not flow properly or efficiently; thus, we will continue insanely repeating the same mistakes over and over again.Having the down payment to establish home equity will not in itself reestablish the healthy lender/borrower relationship. The lender/borrower needs a realistic debt to equity ratio for the relationship to succeed. Unfortunately this debt/equity ratio reveals a problem we have barely begun to talk about; which is, that the overall debt of many consumers is too high to be serviced. Evidence of this growing problem can be seen by comparing the flood of credit card offers mailed in our recent past to the present mailing of credit card offers which is now approaching zero. The serviceability problems of auto loans and student loans is also growing and indicating the severity of the problem posed by high debt/equity ratios. Servicing this total debt/equity is a great problem facing us today. Mortgage payments are just the largest part of the debt side of the equation for most homeowners and future home buyers. Actual declining house values are a symptom of this greater problem. The solution to the real economic problem can only be achieved by establishing a workable, sustainable, debt/equity balance: that is the only thing that can create a tangible confidence in the markets and the restoration of a healthy relationship between lenders and borrowers. Right now we have a great debt to equity imbalance and we do not know what the proper balance should be.Since the bailout bill passed, authorizing 700 billion dollars worth of taxpayer backed funds, my team has come up with one principle step to productively use that money. We are proposing that, on a conditional basis, we immediately freeze home foreclosures and end evictions for the next five years. The borrowers conditions are; first, that the borrower be living in the home; and, second that the borrower agrees to provide equity for a future loan. The lenders condition is that the lender work with the borrower on an appropriate debt/equity ratio that includes realistic mortgage payments, credit card payments, car payments, school loan payments, and any other payments such as medical, utilities, phone, etc. which should have been considered within the terms of the original loan. The meeting of both lender and borrower conditions has the potential to properly restructure a future loan that may be adjusted to future market rates of both principal and interest within the five year period. We understand that people who are in over their heads will be unable to qualify for the new loans as things stand. That is why it will be important for the lender to take guidance of the whole debt/equity reality that the borrower is in and that is why the ‘rent to own with a down payment escrow account’ is the other half of this proposal. It is certainly probable that loans beside the mortgages will have to be renegotiated too. To have the mortgage lender be the only responsible party to the resolution of this debt to equity imbalance is ridiculous, especially when the credit card and student loan companies extended seemingly unlimited amounts of completely unsecured debt to borrowers often only in pursuit of short term corporate profits.The science of economics was in its infancy during the great depression of the 1930’s. We are probably experiencing the wild and frantic teenage years of capitalism today. Today’s science of economics has matured between the great depression and now and what economics now knows must be taken into account. The current bailout proposal, as it is being talked about, seems to take considerable care of Wall Street lenders and it seems to give only lip service to caring for the borrowers. Based on certain conditions as already discussed the freeze on foreclosures and the possibility of converting the property to ‘rent to own’, is the only proposal now up for consideration that will help create a supporting floor under the housing market based on the rental income of that housing capital. It will also help give us at least one year of time needed for economic scientists to experiment with ways to address the proper balancing of debt to equity.The economic realities which we are experiencing today will force us to reeducate ourselves regarding the economic values of money, work and property. Our economic institutions as they stood yesterday, the regulations or the lack of regulations set up by congress, and poor or greedy personal habits have all combined with other external events such as war and volatile energy prices to create what seems to be the perfect financial storm. New thinking that will address both sides of the debt/equity balance is demanded in these times. The old thinking will take care of the institutions because it does not know any way to include the borrowing people: the people it makes money from and the people it uses to make that money.The old thinking cannot measure the pain of the people as individuals or as a community, but it can measure its own pain symbolized by going out of business. That pain of dying as an institution is unacceptable to those in positions of power and they do not like feeling pain. To some extent, the dying of the institutions is unacceptable; but, their painful experience is absolutely necessary and death must be a real possibility. Our institutions are our means of organizing our productive resources. Without them in some form, which may be a new form that is not yet evident, nothing will get accomplished on the scale that will be needed. We have seen in Iraq that wiping out existing institutions and creating new ones from the ground up, with no historical traditions to provide a base from which to do work, simply does not work. Saving evolving institutions is necessary to some degree but not to the exclusion of the people they are here to serve. It is these new economic realities that are forcing a great institutional change in how business will be done in the future across the world. It is the new thinking that is brought into the world by the inheriting generation that must solve these problems. The younger generations must respectfully take responsibility for the living it will be creating for itself from what the older generations are leaving.Jim Cramer, on his show Mad Money, Friday night, suggested a meeting between Paulson, the Fed, and the major surviving banks in which it would be agreed between parties that all problem loans would be taken care of and that each bank would be given 100 billion dollars to loan out on an immediate basis. In principal that is a fine idea but it only addresses half the problem. If there is no equitable reason to give out the loans then we will just compound the problem by just wishing that equity will be created. Do I suppose that we should just trust the bankers to do what is right for all of us? Not on our life! Never again! We need to stop and take a breath even if only for a day.Mr. Cramer also addressed the need to go after the powerful people that should be taking greater responsibility for this mess. And that is very, very, necessary; but, recognize that it is a second concern to the overall restoration of the economy. He also spoke about greed and the hundreds of millions of dollars stolen with careless disregard for the consequences. With regard to that greed, I was reminded of Khruschev’s assertion that ‘capitalism is based on greed’. I believe that is completely untrue. Capitalism, as well as any other form of economic system, cannot possibly survive based on greed. Any system that survives survives only as a sustainable system of working relationships based on honesty, openness, equality, and transparency: greed as well as dishonesty, close-mindedness, inequality and opacity ultimately destroy all relationships. Honesty, openness, equality, and transparency foster all relationships including capitalistic ones.Even though these ideas are very simple and fraught with unanswered questions regarding monetary losses for borrowers, lenders, and society as a whole they will provide a measured step in stopping the bleeding so we can begin the process of recovery. Wasting time playing the blame game just increases the costs and the severity of the injury. Restoring the healthy relationship between borrowers and lenders must start from where we are today accepting that vast sums of money disappeared. So far, all I have heard pundits talk about is restoring the ability for institutions to borrow and lend to each other hoping that some form of healthy borrowing/lending will trickle down to the average consumer once the ability to lend money is restored. We must remember that it is just as important to restore the personal interest for acquiring the property in the first place: that takes equity – for equity is the present measure of economic value personal interest places in the property itself.Now I would like to see what kind of new thinking would come about with regard to the credit card and student loan industries if they were to be reregulated. They might even be encouraged to come up with some realistic proposals on their own if we consider easing bankruptcy restrictions. Imagine if the right to first payment on various held credit cards was actually based on which card has been held the longest and/or on which card has the lowest interest rate. Imagine that the longest held credit card had a credit rating based on the first ten percent of after tax income and the second longest held card had a rating based on the second ten percent of after tax income. Let us just see which banks want to be third or fourth in line to extend the credit that will be treated as though it were a third or fourth mortgage.With regard to student loans it might be a good idea if lenders tied loan amounts to a figure based on average pay over five years for someone graduating with a particular major: say a $40,000.00 salary per year. That would require both lenders and students to consider the potential return on the education for that major. The money borrowed ($40,000.00) could also be amortized over ten years insuring that payment would be roughly ten percent of yearly pay ($4,000.00). This would encourage students to carefully consider the relationship between education, work, and wage. This would also begin to reorient colleges toward more productive educations. It would also take away a fixed upper limit loan amount that it can get from students no matter how well or for what employment they are taught. I would bet that if the government guaranteed that any student could get $100,000.00 in student loans for any four year degree every college would quickly find a way to increase costs to around that $100,000.00 limit. Might this actually lower college tuition costs? It might!By just suggesting regulations such as these, I think we can spur new thoughts as to how to do things differently in Washington in a way which will make a real difference for the average person’s sense of security regarding their family, their retirement and their whole working life.Thank you,***** *****in my imaginationMaury

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Otaviano Canuto

Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He also has an extensive academic background, serving as Professor of Economics at the University of Sao Paulo and University of Campinas (UNICAMP) in Brazil.

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