Maggie's Farm

There were many contributing factors to the subprime mortgage debacle, including the Greenspan Fed keeping interest rates to low for too long.

However, the fundamental problem was twofold. First, irresponsible borrowers took loans with the knowledge that in all probability they could not pay the debt back if the property could not be sold for a higher price. Second, lenders were irresponsible in making loans to borrower that had little chance of servicing the debt because they could make the fees and securitize the loan, passing the risk in theory to another lender.

We all know that the banks got stuck with billions of unsold paper and write-downs have reached about $180 billion worldwide. The first quarter will add billions more to that total. (One ridiculous aspect of this behavior is that the losses will total much more than the profits ever made in the process of originating and securitizing loans.)

Now we are fully facing the moral hazard of bailing out Bear Stearns in what amounts to a giant subsidy for JP Morgan.

The question is what do we do from here?

I have been noodling this idea for a couple of weeks. It has its flaws and comments are welcome.

First, I am disturbed by the $168 billion tax cut, which is largely going to the roughly 40% of people who don't pay taxes in the first place. Second, I call the "beer and cigarette" tax cut because those who receive it will get less than $1,200. The government is trying to stimulate demand with an already tapped out consumer.


I would rather see the $170 billion go into capitalizing an RTC type vehicle with a beginning and an end. Yes, my first criticism with the idea is I don't want the government in the real estate business (anymore than it already is with Fannie Mae and Freddie Mac and so on). Let me get the idea out and then point out the pros and cons.

The new "Real Estate Recovery Fund" (RERF) would purchase properties to be foreclosed upon for the value of the mortgage or a small discount to that value. The borrower would lose his equity and bear the burden of a foreclosure in his credit history. The lender would feel some pain too.

The occupant would not be evicted but the property would be converted into a rental property. At some point, the properties would be sold as income producing and the RERF would recover some of its investment.

What would be the criteria for qualification to participate in RERF? I don't fully know.

Why do this? One, stabilize the home prices. Occupants are evicted when a property is in foreclosure. Depending upon the location, the homes fall into disrepair and are often vandalized or can turn into drug houses, among other things. These dynamics place the foreclosed upon property and surrounding homes under additional price pressure further exacerbating the problem.

Demand was artificially stimulated by low interest rates, easy money and ever increasing housing prices. Now the pendulum is swinging back. Supply and demand will normalize albeit at a lower equilibrium point.

Second, the taxpayers have some chance of a recovery versus a beer and cigarette spending bill. The economy could be helped by limiting the additional damage caused when properties are abandoned in foreclosure.

Third, there would be an economic penalty to borrowers who would lose their equity (versus Bernanke's idea that the lenders forgive a portion of the loan, rewarding the irresponsible borrower with continued property ownership).

The originators and lender would also need to feel some pain for making loans that could not be repaid. This could be an escalating percentage for lenders that made more bad loans as a percentage of their total mortgage loans.

Yes, some banks probably should fail, but the systemic risks (e.g. counterparty risk) could be worse than anyone could imagine. Credit default swaps total more than $300 TRILLION.

We are going to have a recession of some magnitude. I have not even mentioned losses tied to leveraged loans, credit cards, home equity loans or auto loans. The credit losses this cycle will be larger than anything ever seen. We have not even seen the negative macro-economic impact of the banks that have all but stopped lending to creditworthy corporations and individuals. This will not be seen for another six months.

I don't like the idea of government being in the real estate business (in fact, I don't really like government at all in most cases). I don't want to bail out irresponsible borrowers or lenders. I also don't want to see a collapse of the financial system.

I am not sold on the idea, but I am concerned about where the credit crisis could take all of us. We need to have functioning credit markets to have a healthy economy.

Comments please.