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The Trickle-Up Bailout
By Jonathan G.S. Koppell and William N. Goetzmann
Wednesday, October 1, 2008; Page A17

The theory underlying the bailout plan stalled in Congress is that rescuing the finance industry will restore market stability and that the benefits will eventually trickle down to average Americans. Thus, solving the subprime mortgage crisis has morphed into a much larger challenge: reassembling the architecture of the financial markets, which seemingly requires giving the Treasury secretary nearly a trillion dollars and extraordinary latitude to pick winners and losers.

There is an easier and more politically palatable fix: Pay off all the delinquent mortgages.

The financial crisis is a liquidity crisis, yes, but it is ultimately a product of homeowner failures to pay. Unless this fundamental problem is fixed, we will continue to see -- and need to treat -- the symptoms. The proposed bailout ignores this. Yet the sum being demanded from taxpayers is almost certainly more than sufficient to pay off all currently delinquent mortgages.

If the government did this, all the complex derivatives based on these mortgages would be as good as U.S. Treasuries. Their fair value would jump to 100 cents on the dollar, rescuing teetering financial institutions. The credit markets would be resuscitated overnight. Foreclosures would stop.

Some will argue that it is grossly unfair to pay off the mortgages of borrowers who took risks and lost. In other words, why should my profligate neighbor be rewarded for overleveraging himself?

Because such unfairness is a small price to pay to avoid a rapid transition to a socialist economy, the collapse of our financial system (and its related global implications) and a frightening shift of economic power toward the executive branch. Why shell out $700 billion to Wall Street dealmakers and the companies they managed into this mess? Wouldn't it be preferable for individual homeowners to benefit directly?

Implementation could follow the example of the Home Owners' Loan Corp., which in the 1930s issued new mortgages to a quarter of American homeowners. The government could offer to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent. No credit scores, no questions asked; just pay off the principal of the existing mortgage with a government check. If monthly payments are still too high, homeowners could reduce their indebtedness in exchange for a share of the future price appreciation of the house. That is, the government would take an ownership interest in the house just as it would take an ownership interest in the financial institutions that would be bailed out under the Treasury's plan.

All this could be done through the Federal Housing Administration, with the help of Fannie Mae and Freddie Mac, which have the infrastructure to implement this plan rapidly. An equity participation structure would prevent thousands of foreclosed homes from being dumped on a strained housing market and would allow prices to reach a new equilibrium that is based on realistic demand for houses rather than on easy money or impending foreclosures.

Like the administration's proposal, this plan would result in the government owning assets. But these assets would be real estate, not complex derivatives whose true value would take weeks to discern. Homeowners would become partners with the government in resolving the crisis.

When Congress returns, lawmakers are likely to modify and then pass the administration's bailout proposal. They should consider ways to implement this bottom-up solution. Combining this approach with the government's proposal could greatly benefit taxpayers. Yes, the government's swift purchase of illiquid securities would stabilize compromised financial institutions and the credit markets. But the notion that taxpayers would benefit in the long run is pure speculation, particularly if the government overpaid for the securities. On the other hand, once a government-sponsored refinancing wave kicked in, the full value of the securities in the government's portfolio would be restored, and they could be sold off in an orderly manner, with Uncle Sam taking profits that would cover the cost of the bailout.

The public is rightly concerned that the administration's bailout would benefit only powerful financial institutions. No matter how it's done, rescuing the financial system is a large, complex gamble.

This solution would start by helping ordinary Americans and would quickly spill over to revive the financial markets. Directly addressing the underlying cause of the crisis would help ensure that we would not be facing the same crisis again down the road. While Wall Street has only recently felt the bite of foreclosures and delinquencies, communities across the nation will face greater financial and social fallout if the foreclosure crisis continues.

Jonathan G.S. Koppell and William N. Goetzmann are professors at the Yale School of Management. Koppell is director of the Milstein Center for Corporate Governance and Performance and Goetzmann directs the International Center for Finance.

I think Dennis Kucinich is supporting something similar to this. I really don't have the expertise to have an informed opinion, but on the face value, it does sound preferable. And the feds could work out a lower payment plan so it's not just a give-away.

Trevor wrote:Why shell out $700 billion to Wall Street dealmakers and the companies they managed into this mess?

I prefer that they simply split the $700 billion between each citizen and send us the money directly.

Trevor wrote:The Trickle-Up Bailout
...If the government did this, all the complex derivatives based on these mortgages would be as good as U.S. Treasuries. Their fair value would jump to 100 cents on the dollar, rescuing teetering financial institutions. The credit markets would be resuscitated overnight....

I can’t tell if these guys are lying or don’t know what the hell they are talking about or simply had a brian fart. (Or maybe I'm missing something?)

As an example, some CMOs give the owners only the principle portion of the mortgage payment (PO strips), while others only get the interest portion (IO strips). PO strips are sold at a discount--somebody might pay $50,000 for a PO strip that will eventually pay $100,000 as the principle on the mortgage is repaid. Somebody else will buy the IO strip. It will only pay the interest portion of the loan.

If the government suddenly paid off the mortgages, the owners of the PO strips would be huge winners (e.g. a bond purchased for $50,000 two years ago is now worth $100,000!), while owners of the IO strips would be huge losers (e.g. somebody who paid $50,000 for a stream of interest payments over the next 30 years would get a stream of interest payments that ends now).

Analytics wrote:If the government suddenly paid off the mortgages, the owners of the PO strips would be huge winners (e.g. a bond purchased for $50,000 two years ago is now worth $100,000!), while owners of the IO strips would be huge losers (e.g. somebody who paid $50,000 for a stream of interest payments over the next 30 years would get a stream of interest payments that ends now).

Why would they have to pay them off "suddenly?" Why can't the pay off account for a reasonable amount of interest? Why not just guarantee the mortgages instead of buying them outright?

Analytics wrote:

Trevor wrote:... while owners of the IO strips would be huge losers (e.g. somebody who paid $50,000 for a stream of interest payments over the next 30 years would get a stream of interest payments that ends now).

So it is better for the taxpayers to take it on the chin, in order to make profits for a few?

Trevor wrote:

Analytics wrote:If the government suddenly paid off the mortgages, the owners of the PO strips would be huge winners (e.g. a bond purchased for $50,000 two years ago is now worth $100,000!), while owners of the IO strips would be huge losers (e.g. somebody who paid $50,000 for a stream of interest payments over the next 30 years would get a stream of interest payments that ends now).

Why would they have to pay them off "suddenly?" Why can't the pay off account for a reasonable amount of interest? Why not just guarantee the mortgages instead of buying them outright?

If they didn’t pay it off suddenly, it would be a situation where they’d be collecting mortgage payments from the homeowner for 6%, then adding 4% to that to pay the original issuers. That would be a way to guarantee that the government loses money on the deal.

moksha wrote:

Analytics wrote:... while owners of the IO strips would be huge losers (e.g. somebody who paid $50,000 for a stream of interest payments over the next 30 years would get a stream of interest payments that ends now).

So it is better for the taxpayers to take it on the chin, in order to make profits for a few?

Or course not. My point was that this simplistic proposal would cause problems on Wall Street.

The bottom-up bailout would absolutely slaughter holders of IO bonds. On the other side of the equation though, this “bottom up” plan would create extraordinary windfalls for most of the Wall-Street-Greedy types who engineered this mess. While the top tranches would go back to AAa value, the bottom tranches would too. People that originally purchased these junk bonds for pennies on the dollar with the hope that they’d eventually pay, say, 25 cents will all of the sudden get $1.00 too. My prediction is that the “bottom-up bailout” would create the biggest profits and bonuses this industry has seen in its history.

Seriously. The “top-down bailout” plan would allow the government to add liquidity to the market by purchasing a distressed bond at a theoretical fair value—say 70% of its face. The holders of the bonds would be happy to get rid of it for that amount, and the government stands the chance of making a serious profit. The bottom-up plan would allow the same owner to sell the same bond for 100% of its face. That should be a huge warning flag that the “bottom up bailout” would be a lot more expensive to taxpayers than the top-down bailout.