Plan B, from Luigi Zingales

Find it here.  In a nutshell:

Congress should pass a law that makes a re-contracting option available to all homeowners living in a zip code where house prices dropped by more than 20% since the time they bought their property.

Thanks to two brilliant economists, Chip Case and Robert Shiller, we have reliable measures of house price changes at the zip code level.  Thus, by using this real estate index, the re-contracting option will reduce the face value of the mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property.

…In exchange, however, the mortgage holder will receive some of the equity value of the house at the time it is sold. Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder.

Zingales also stresses that half-hearted attempts at bank recapitalization are unlikely to work at this time; he thinks that at least $600 billion would be needed.

This piece has many interesting points throughout, it is worth a full read.  Here is a concordance of writings of Luigi Zingales on the credit crisis.


If renegotiation would work, why aren't they already doing it? I doubt banks want to go out of business.

Doing this won't claw back the 20% profits made by the sellers. That money is gone. Renegotiating will front-load the losses, no?

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"Until then, the homeowners will behave as if they own 100% of it. It is only at the time of sale that 50% of the difference between the selling price and the new value of the mortgage will be paid back to the mortgage holder."

Uh, maybe I don't understand something here, but _why_ would the homeowners behave as if they own 100% of the house if they only get 50% of it? Why, say, would you spend $10,000 on a termite extermination that would add $15k to the house if you only get to keep $7.5k of the profits?

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Wouldn't this violate the contracts clause of the Constitution? I know it's a quaint objection, but still...

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Classic debt-for-equity swap?

Yeah, sure.

Still, I wouldn't put this approach high on the list. For its short-term salutary effects, I'd prefer the government to be the one in the middle, paying the lenders, at some haircut of the price-decline, and holding any compensatory long-term equity stake, if any.

For one, you'd be operating within existing legal frameworks, for the most part, by doing that.

Also, how do banks account for this new asset, called 'contingent home equity'? It seems fraught with problems (at least as many as trying to specify what the work-out price of the home would be for the purpose of refinancing, because there is no market price). Also, the regulators are likely to ask for more capital against equity stakes versus mortgage debt, so ...

Off the top of my head, I'd say that it would be important for the debt (mortgage) to trade separately than the equity interest, or you will have invented the 'Home Equity Loan Participation Mortgage' (HELP-'EMs).

Unintended consequences check?: looking into the crystal ball, would the market-impact of this change be that private lenders simply require a minimum cushion of 20% on all home financings, i.e. max of 80% loan-to-value?

[Separately, Steve, perhaps you ought not to stoke racial passions, because (a) there are no racial solutions and (b) you do not have the pertinent data to make a case, as you say, namely, the default rates among minority lenders, adjusted in the appropriate ways ...]

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This plan won't work. Despite all the arcane jargon, Zingales plan is a simple solution: force all banks with liquidity problems declare bankruptcy and convert their current debt (excluding personal deposits) into equity. Does he really think the current debt holders so stupid? If this plan is really accepted by government, most likely all these debt-holders will pull out the money and flee to Treasury bills. In one day the whole financial industry will be non-existent. Another 'shock therapy', eh?

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I contend that the intervention by governments with public money is neither desirable nor inevitable. It is not sufficient nor necessary. The more governments intervene and politicians speak the more the market is getting scared and get into panic, a kind of self-fulfilling prophecy. It is difficult and perhaps useless to recapitalize banks before cleaning their balance-sheets or setting or enforcing new rules for the banking systems, bank governance and management accountability. It is not true that some banks are too big to fail. Let them fail and the market to clear the mess. Eventually a new banking system could be set up, maybe already in parallel, under transparent rules, clean balance sheets and surveillance and if needed some public money or maybe International Monetary Fund umbrella (I wonder why IMF is not called into question if the problem is global or even national). Market-based instruments and solutions (mortgage restructuring and renegotiation, Danish mortgage-bond system, etc.) should, as the author suggests, aim at main street not rotten banks. The deleveraging of banks is ongoing and maybe some hedge fund is "simply" unloading some heavy positions. Let's put public money to better use thinking global but acting local where the problems are. Why should we continue to invest and waste money on organizations which have not done what they were supposed to do, that is allocate efficiently resources and manage risks? To this question most of the economists and politicians still have to answer. Hopefully without public money and interventions. If public money is to be used let's set up banks completely separate from the rotten ones. I am sure we will find investors and savers for the news.

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I just discovered Zingales plan and was very impressed, at least with the mortgage part, probably because I thought of it over a month ago.
Then I read some of the comments on this site and was flabergasted. So I feel compelled to respond to some of the comments.
1. As to why renegotiation isn't working already, that is very complicated. Have you ever looked into a banker's eyes? I ask that partly in jest. The simplest answer to why renegotiation isn't working is the ownership of the mortgages is so diluted there's no one to negotiate with. Sad.
2. Why do homeowners already act as if they own the house, when they only have a 10% interest?
3. What would be the incentive for selling early? So you could lose more money faster? This plan would only apply to borrowers who wanted to use it (a free market idea), to keep some ownership in their house, which I still think is better than being a tenant or homeless.
4.I actually like the idea of 'Home Equity Loan Participation Mortgage' (HELP-'EMs).
5. If the regulators required more capital against equity, that would be a good thing. 20% equity on all mortgages used to be known as sound business practise.
6. Yes. The current debt holders are "stupid". They bought worthless mortgage products, and expected a return. They can't just pullout their money because the "bigger fools' are rapidly dwindling.
7. This would not be a disincentive to home improvements. It would be a 50% incentive for home improvements. As it is now if your going to lose your house,or your upside down, you have 0 financial incentive for home improvements. Plus if your living in the house you directly receive the immediate benefit.

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"Why do homeowners already act as if they own the house, when they only have a 10% interest?"

Homeowners with standard mortgages have debt, not equity, and so they have a 100% share of marginal changes in value. I'll pay $10,000 in cost to add $15,000 in value because all of that value goes to me; it does not increase the amount owed to the bank.

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