The Subprime Crisis—Plan C

The just enacted $700 billion Plan B to put a floor on the market prices of mortgage related assets may not be enough to restore credit markets to normalcy, though the Treasury has yet to settle on just what Plan B is.  What should Plan C look like?

When the bursting of the real estate price bubble began to dramatically increase mortgage defaults and foreclosures in the spring of 2007 (especially for adjustable rate mortgage loans to subprime borrowers), banks began to horde liquidity and heavily indebted hedge funds and others began to deleverage. The three month LIBOR, the rate at which banks lend to each other, which normally averages between 0.1 and 0.2 percentage points above the overnight Federal funds rate, suddenly jumped starting in August 2007 to more than triple those spreads by mid September reflecting a lack of confidence in the borrowing banks.

In Plan A the Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (all Federal Reserve Bank loans are collateralized), and broadened the institutions that could access these new facilities. The money supply (M2) grew above its normal rate throughout this period. Lenders were encouraged to renegotiate the terms of mortgages if foreclosure could be avoided and the lender incur a smaller loss. Plan A included bank by bank interventions and resolutions of failing commercial and investment banks starting with Northern Rock in the U.K, followed by Bears Stearns in the U.S. and later by Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia to name the bigger ones. But still the three month LIBOR spread over the fed funds rate persisted in the 0.7 to 0.8 percentage point neighborhood.[1]

Following the September 15^th bankruptcy of Lehman Brothers and the government take over of AIG the next day financial markets panicked and by the end of the month the LIBOR spread more than tripling again from its already extremely large value (to 2.4 percentage points) and credit markets largely froze up. Regrettably more radical intervention was needed. Having largely addressed the “liquidity” problem the Federal Reserve and U.S. Treasury began to focus on the “capital” problem. The write offs of mortgage losses and the prospects of more to come led banks to question the soundness of their counterparties (those other banks to whom they generally lend short term money) and limited what they could lend even if they had the liquidity with which to do it. Thus the rapidly conceived and still unspecified Plan B for Treasury to buy up and insure mortgage related assets held by banks in order to help improve their capital. Plan B seeks to free up the flow of credit to “Main Street” by bailing out “Wall Street.” Depending on the details of its implementation it might succeed, especially if intervention takes the form of direct capital assistance (preferred shares) to all but the weakest banks (which should be resolved in the traditional way if they are not able to come up with enough capital on their own). The best plan would be to immediately guarantee that the government will take a significant, specific share of any actual loss on any mortgage. This plan could be implemented immediately with an immediate increase in the value of all questionable mortgages and of the capital of the banks that hold them.[2] It would share the loss with, and thus reduce it to, lenders but would not eliminate it completely.

Plan B does little to help homeowners unable to meet their mortgage payments. Reducing mortgage defaults is the most fundamental way to reduce Wall Street losses and increase bank capital. It is being called a “trickle up” rather than a “trickle down” approach. The administration and Congress have been rightly concerned not to tax those who borrowed prudently to bailout those who borrowed foolishly or who speculated on increasing housing prices, or to change lending rules in ways that increase the costs of mortgages in the future (such as court order debt restructuring). It has pressed for voluntary loan restructuring with HOPE and beefed up the FHAs assistance programs. However, we now need to carefully consider a radical Plan C that helps home owners with minimum unfairness and moral hazard of encouraging imprudent borrower behavior in the future.

Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.” [3] McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment.[4] Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.

To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to 180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)

Let’s start discussing the details of Plan C before poorly designed versions are forced through a panicked Congress and before the unavoidable losses on other credits as the economy slows add to the erosion of capital.