Jeffrey Ely’s mortgage proposal

by on September 24, 2008 at 3:03 pm in Economics | Permalink

We all need more creative thinking and Jeff is one of the best people to supply it:

True just sending money is not incentive compatible. But there is no reason to bail out homeowners. Just intervene in any mortgage default. Seize the property and continue making the mortgage payments. In the short run rent the property back to the homeowner.

This is what I have been advocating to my colleagues. I don’t know why it is not under discussion. Before going with the arbitrary implememtation that Paulson is proposing now there should be some convincing argument that it’s more efficient than this alternative. It is clearly the most direct approach and therefore should be the default (so to speak.)

Thoughts?  Unlike Tyler (and some others), Jeff is not obsessed with Jonathan Swift.

1 Jim Hu September 24, 2008 at 3:07 pm

Or let returning veterans live in them rent-free.

2 y81 September 24, 2008 at 3:15 pm

The Treasury Department has (or can hire) the expertise to buy and hold $700 billion of securities. The Treasury Department does not have, or know where the find, the expertise to own, manage and rent 3 million houses.

3 Norman Pfyster September 24, 2008 at 3:42 pm

I wonder what he means by “efficient”?

I agree in part with DRB: Paulson is focused on bank’s liquidity. The above proposal does address this by in essence guaranteeing every mortgage in the U.S. A true bailout: the banks lose nothing and homeowners lose their equity, but have their rent subsidized.

Also, see the Takings Clause.

4 no September 24, 2008 at 3:51 pm

Isn’t this the Baker/Samwick proposal?

5 Andrew September 24, 2008 at 3:52 pm

This just doesn’t seem right.

It can’t really be that the problem is the securities aren’t worth anything. I don’t know nuffin’, but mustn’t it be that the sale effectively books the losses?

I’ve seen no discussion of eliminating the mark-to-market rule. Of course, I only read MR.

6 BAM September 24, 2008 at 3:56 pm

Let the private sector do it. Stimulate private actors to buy these distressed properties and turn them into rentals by temporarily eliminating or dramatically reducing federal income taxes on residential rental incomes for a period of time (3-5 yrs?).

7 Adam September 24, 2008 at 4:01 pm

So the government takes the loss on the depreciated value of the home, rents the home to the (previous) owner at market rates, and pays off the banker who made the original loan. Tell me:

1) Why this is incentive compatible: You are bailing out the homeowner (who now gets to live in his too-expensive house for a lower monthly payment) and you are bailing out the mortgage originator (who gets a risk-free monthly mortgage payment for making an extremely risky loan)?

2) Why this plan differs from a plan where the government buys the mortgage from the banker, writes down the loss from the depreciated home, and refinances the mortgage to the owner at current market rates. I’ve heard of this plan already and it’s called the Paulson plan.

8 Marshall September 24, 2008 at 4:05 pm

I had similar thoughts, as well. It seems as though the level of intervention to stave off further deterioration in the credit markets is imprecise and misplaced. Since the mortgages within the toxic CDOs cannot be properly evaluated to determine the ex ante risk and prevalence of default (and consequently their worth), why not focus the intervention on the individual mortgages within these instruments? The entire proposed bailout seems to suffer from an ecological fallacy, no?

9 8 September 24, 2008 at 4:11 pm

What about opening up Colorado, Utah, Wyoming, offshore and elsewhere to mineral and energy extraction, in addition to selling some federal land? Sell anything that has value: spectrum, pollution credits, etc. Let home prices and mortgages fall where they may, and use the sales revenue as a credit backstop.

Or, buy the mortgages and attach mineral rights as a sweetner. Buy an Alt-A death pool and we’ll throw in a free coal mine in Utah. But wait, there’s more! If you call in the next 30 minutes…

10 floccina September 24, 2008 at 4:14 pm

There must be some way for people with cash to profit from all this. All ideas apreciated.

11 Diversity September 24, 2008 at 4:25 pm

Ideas like this have been circulating in Britain for some time. The problem in implementing them is the clumsiness of central government.

However a programm of modest susides for the sort of enterprise floccina has in mind might do the trick cheaply and effectively.

In passing, has anyone any where suggested a plan which looks less efficient than Paulson’s?

12 adam September 24, 2008 at 4:29 pm

OK, you asked for thoughts. I apologize in advance.

What are the market failures and what is the potential role of government?

1) The contracts underlying the CDOs and MBS were inflexibly constructed and failed to foresee forclosures that arise because of falling home prices. This has created a classic public goods problem. The diffuse ownership of cash flows from the underlying mortgages, the complexity of the securities, holdout problems, etc. mean that efficient renegotiations and modifications of mortgages cannot occur.

In the old model, forclosures were the result of idiosyncratic income risk for homeowners–the guy couldn’t pay his mortgage so you took the property and sold it at market prices and received the value of the home as collateral, minus a LARGE transaction cost (something like 20-40 percent or even larger). It’s premised on the idea that the person in the home would not be the highest bidder on the property. Maximizing profit usually implied foreclosure.

In the current crisis, mortgage delinquency is the result of people having negative equity in their homes because of falling prices and choosing to walk away. In this case, the person in the home probably is the high bidder on the property–but at the lower market price. In this world, you would save the transaction costs and strike a better bargin by renegotiating the mortgage with the homeowner. You’d make the homeowner better off and the mortgage creditor better off.

The public goods problem is that the structure of the CDOs and MBS prohibit these efficient transactions. These mortgages are held in pools, the cash flows are directed to MBS, which are in turn, repackaged into CDOs. No one has direct ownership so no one can direct the mortgage servicer to renegotiate the mortgage. When there are multiple mortgages on a property, renegotiating one mortgage benefits the other mortgage holders, so no one is willing to go first.

Potential solutions to this failure:

1) Buying second lien mortgages with the $700 billion and just writing them off: These are worth virtually nothing right now anyway, and by getting rid of second liens you would make it more attractive to first mortgage holders to renegotiate those mortgages–reducing forclosures and “unlocking” value.

2) Buying entire chains of MBS and CDOs. If you owned every claim on every mortgage in a pool of mortgages, you could unwind the CDOs and MBS, eliminate the conflicts due to multiple ownership, and renegotiate the mortgages.

3) Reform bankruptcy: Allow judges to re-write terms in these mortgages, effectively writing down the principle to appraised value or ability to pay (or whatever the judge arbitrarily wants). This solves the renegotiation problem by disolving the contracts, but I’m not sure that Judge Judy’s court is the right place for these things to be worked out.

4) The government disolves the contracts another way outside of bankrupty, like having a housing authority do the work, or authorizing mortgage servicers to renegotiate mortgages held in MBS or CDOs. Basically the model is the same for delinquent credit card debt—you force the unwinding of the CDOs and MBS and then auction off the individual debt to the private sector. Let the private creditor and the homeowner strike a bargain and avoid forclosure when it’s efficient to do so.

Bigger problems:

2) Lack of liquidity in the mortgage security market (the Administration’s view of what the failure is). Everyone is trying to dump their securities at the exact same time, pushing down prices due to liquidity rather than because the value of these assets is fundamentally low. It’s like in the development literature when everyone wants to sell their ox when the harvest fails–you can dump assets when hit with an idiosyncratic shock, but not when it’s a correlated and undiversifiable risk. If you think the government has a role mitigating undiversifiable risk for which no private market can address, then you’d think the government should come in and soak up that risk.

Currently, this problem is compounded by accounting and regulatory rules that force companies to mark their assets to market–everyone’s dumping assets at firesale prices, everyone else then has to mark their assets to those firesale prices, this makes everyone’s balance sheet look terrible, so everyone has to dump more assets at even lower prices….. Or, as I think has been happening at a lot of banks like Lehman, they have been refusing to mark to market and have been pricing their assets at what they believe is fair value, which has made them fodder for the shorts who can correctly claim that they are valuing their assets much higher than everyone else.

[I am skeptical of this view because there is a lot of money floating around in hedgefunds, private equity, soverign wealth funds, distressed debt funds. I think the truth is that these assets really are just not worth very much.]

One solution is to take the $700B and make a market for these securities; try to value these in a NPV sense and pay that price–above the liquidy-reduced price one can get in a firesale, but below a price that would force taxpayers to take a loss. Basically soak up the undiversifiable liquidity risk premium.

Of course, if these things are actually trading at NPV then the government’s plan doesn’t do anything–balance sheets are still too thin to go about business normally–unless the government over pays for the assets. If we start paying too much, then we’re just re-capitalizing the banks by giving the banks with the worst assets, the most egregious business practices the most money. Not good incentives.

3) Network externalities when banks have thin capital reserves. All banks have been hit, to a lesser or greater degree, with a big negative shock to their assets which has pushed all of them close to insolvency because of how leveraged they are. Furthermore, banks are so connected these days–they are counterparties to each others transactions, hold each others bonds and stocks, and are more generally on the hook for each others losses. If one goes, others will go, as we saw with Lehman effectively taking AIG down (AIG “insured” Lehman’s debt through credit default swaps).

The private market is able to deal well with idiosyncratic risk—the risk of one firm going under—because they can diversify and insure, but isn’t good at deal with multiple, correlated risks created by the fact that banks are so interdependent. Judging by OIS or TED spreads, the risks of multiple failures seems really high (they obviously cannot diversify the risk of banks failing overnight). I think this network externality and more generally, this undiversified risk of interbank lending is the key problem. No one wants to lend to anyone else.

The solution here is just to recapitalize financial intermediaries. If we did, as Elmendorf suggests, buy up X% of many banks for cold cash, most banks would no longer be at risk of failure, and more importantly, banks would know that their counterparties would no longer be at risk of failure. You’d get rid of the network failures, you’d reduce the undiversifable risk of interbank lending, and you’d get banks lending again. A further benefit, is that you wouldn’t reward the bad banks anymore than the good banks–you’d have a flat X% of the entire sector and the bank that made really stupid moves, they’d get X% – their stupid losses; Goldman would get X% + their gains. We reward winners and the incentives are better.

I also think this has a better long run return for the taxpayer–whereas I don’t have good sense that we would get a good price on individual mortgage securities, I do think we’d have a better chance of getting our money back if we just bought 10% of the financial sector at current prices. Wall Street will make money in the future. And hey, we already “own† 30% of the financial sector because of the corporate income tax, dividend tax, and capital gains tax, so why not a little more?

13 jim September 24, 2008 at 4:53 pm

The assets are worth whatever you can sell the underlying houses for in a nation-wide fire sale to buyers with good credit. The problem is that foreclosure and resale takes time and people and nobody wants to buy that headache. There are lots of deserving renters with good credit histories who sat out the bubble and would buy a home at the right price.

14 alper September 24, 2008 at 5:28 pm

This proposal is ingenious as it prevents placing the house in “regular” foreclosure which will lower the market value of other houses while keeping general renting costs down (assuming that lower house prices will raise rent). However, the aim of this proposal should not be to stop falling house values, rather slow down the process and let the market clear.

y81: If the government can hire expertise to buy and hold securities, what stops it from hiring expertise in renting houses?

15 Joan September 24, 2008 at 6:03 pm

Since the expectation is that housing prices will continue to fall for at least another year because they are still high by historical standards compared to both rents and incomes, programs aimed at homeowners to lower mortgage amount will still leave risky mortgages in the market. Renting homes will result in even lower market values of homes, because the increase the supply of rental units will lower rents, making buying a home a less attractive option. The market will eventually sort out the pricing problems but until it does and prices are stable, helping home owners will not solve the the problems in the credit markets.

16 Jeffrey Knoll September 24, 2008 at 6:12 pm

Here’s my idea of a government plan: the government does nothing. Housing prices fall to their market levels. Those people who can’t afford their mortgage payments foreclose and end up renting at much less per month. These people don’t lose much because they didn’t put much down anyway. The real losers are the banks who hold the mortgage securities. Those that took too much risk will go bankrupt. Those banks that made wiser investment decisions grow and take their place. The fact that the bad banks go bankrupt will free capital and labor making it easier for the good banks to grow. No resources will need to move from the productive sectors of the economy to maintain a bubble for the purpose of saving inefficient companies. If we try to save these poor companies, we can only do so by taking capital from the more productive areas of the economy and we will become trapped in a never ending recession.

17 PA September 24, 2008 at 6:56 pm

Dean Baker at “Beat the Press” ( has been suggesting this for some time now.

18 Mercutio.Mont September 24, 2008 at 7:46 pm

Hoover didn’t take Mellon’s advice. If he had, the GD may have been much shorter and less severe.

19 Nick September 24, 2008 at 9:14 pm

Or let returning veterans live in them rent-free.

This starts to get at the problem with all these creative proposals for using “the government” to bail out “the economy.” The problem is that they make the same old assumption, which should long since have been debunked, that a government can implement a plan optimized for the public interest rather than for the interests of the most effective politicians and lobbyists and their supporters. Now that we are in a Panic, even libertarians (who have after all also grown up in our culture where this assumption is ubiquitous) rush to the arms of the omniscient government run by omnibenevolent public servants with our grand theories about what you would do, or I would do, or the professor down the hall would make the rest of the world do if one of us wise people were made philosopher-king. Isn’t this a rather adolescent, or even pre-adolescent, fantasy? But that is what we turn to in a Panic.

The fact is that if you put a new $700 billion out there, it will become (and indeed already is becoming) the prime target for massively wasteful special-interest lobbying. In the case of Ely’s proposal, we will end up with people who took out mortgages they knew or should have known they could not pay for living rent-free or with highly subsidized rent at taxpayer expense. Veterans are just the tip of the iceberg. Do you really think Barack “Mr. ACORN” Obama in control of $700 billion is not going to use it to pay back the people who got him where he is today? Do you actually think McCain or the Treasury Secretary he chooses won’t do something similar for their own constituencies? It won’t just be veterans, it will be every victim group with artfully pitiful wails or arguments that they deserve it more than the next guy. It will be every Wall Street and Main Street banking and finance interest with clout on K Street. All our creative ideas are just so much hot air unless they help a powerful lobby or political constituency win the money.

It’s much more useful to predict what McCain or Obama would actually do with the money to pay off their supporters and punish their opponents than to creatively provide them arguments and resources for doing so.

My apologies for interrupting our splendidly hysterical Panic and flight-to-government with some common sense observations. Now back to the crying and gnashing of teeth about how we’re all doomed to enter the next Great Depression if the Great Gods Paulson and Bernanke aren’t given more power to save us from ourselves.

20 Andrew September 25, 2008 at 7:16 am

Nothing very good happens very fast. Other than your sports team winning a game, which is of course, bad for the other team.

21 wintercow20 September 25, 2008 at 10:17 am

How would such a plan get foreign claimants out of the picture? There are extraordinarily complicated legal issues that arise regardless of how you structure any such plan.

22 Eric September 25, 2008 at 2:05 pm

Why do we call them homeowners? It makes them sound so much more sympathetic, where it’s just false in a lot of cases. Maybe “people who tricked greedy underwriters”? I’m lacking a way with words here. When you change the terms this sounds a lot better.

23 TC from Cali September 29, 2008 at 8:03 pm

“People who tricked greedy underwriters”? Ha, ha – that’s a nice way to put it! How about maybe greedy bank analysts who created the risky and unrealistic loan programs that allowed the outrageous home prices in the first place. How convenient is it to come down on the people everyone claims tricked the underwriters into letting them get a loan for a home they couldn’t afford when in actuality that is only the end result of all this. Nobody was wagging their tongues when they master-minded the plan to allow sub-prime loans to be the PRIMARY form of home buying in certain parts of the country and were cashing checks and feeding excessive materialism at its best. Yes I’ll admit there were some poor decisions made – but it didn’t start with the “irresponsible” borrower and frankly if you are a lender who is really trying to do good for your investment – why would you lend your money to someone who can barely qualify to pay say $2500 in interest payments and in 5 years is supposed to give you $5000 for the same raggedy house! Even if they could afford it why would they want to – especially when Joe Smo across the street just bought your same model for half the price you paid for it! Tell me what would be the incentive?? Even if you are a “prideful home leasor” which is really what anyone mortgaging a home is why would you want to pay $5000 for a house that for all intents and purposes isn’t really worth that anyway – the price was just inflated because the home builders or previous homeowners could do that because the stupid banks were willing to loan anything to anybody to make a quick buck! Anyone ever heard of long-term planning? You can’t tell me that the analysts on Wall Street really thought that the prices of homes would never hit a brick ceiling and people would just continue to pay $1 million for the 2 bedroom dollhouse in San Diego that just under 30 years ago somebody probably paid $20K for – give me a break!
Call me whatever you want – but guess what I live in an overpriced California home that in other parts of the country sold for half of what I paid for it, and guess what it’s worth now – half of what I paid for it! Starting this month I’ll be happily keeping my $5100 in my bank account until the day the bank decides to tell me to beat it and while I’m saving for the real house of my dreams I will be renting some classy house that’s probably going to be nicer than the one I have now for a portion of the cost. And when it’s time I’ll go buy that house of my dreams with a down payment and a conforming loan for less than I bet I’m paying for this squatter I have today. And I don’t and won’t feel a bit bad about it! And God bless that lucky dog that gets this house after me – because he’s really going to be paying what this house is worth – and not the sub-prime “get rich quick” price I decided to pay kicking and screaming all the way.
This my friends is what you get when you try to take advantage of people who have nothing to lose – a clogged up financial market and smart investors who balk at you. Sure there is the ripple effect, but it’s never good business to take advantage just because you can. It doesn’t build loyalty and long term you’ll never last. If we all have to suffer a little to learn that in our society it is WRONG to take advantage of people then so be it. I’ll tell you what if the banks were really serious about getting it right they would go to the root of the problem, take responsibility for their part of it, and start figuring out how to untangle the mess that is the portfolio of overpriced-undervalued so called assets they have created for themselves and start operating in reality and get to renegotiating, because apparently that fantasy world that everyone has been living in the past 7 years or so where people were entranced by greed and consumption and were having a good time off of ill-gotten riches – well sounds like the alarm clock just sounded!

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