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A Better Bank Fix: Cut Every Mortgage's Principal
By Ari J. Officer Friday, Feb. 13, 2009
fixing banks trimming dollars
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Treasury Secretary Timothy Geithner has unveiled a new plan to combat the financial crisis: convincing private financial institutions to buy up "toxic assets" with the government's backing. While this is a step up from former Secretary Henry Paulson's original bailout plan—in which the government itself would buy up the bad securities—it is still not the right approach.
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Instead, there is a better, cheaper, less risky, more direct way to improve banks' balance sheets and restore confidence. Here's how:

Reduce the outstanding principal on every single mortgage to, say, 70% of the original value. Yes, you read that correctly: Lower every single American's mortgage debt by a fixed percentage. (See 25 people to blame for the financial crisis.)

If homeowners owe less money on their mortgages, they will be less likely to stop making their payments. The plan is equivalent to a universal renegotiation of terms that improves the situation for both homeowners and banks. As a bonus, mortgage-backed—and, indeed, all mortgage-based—securities will become less "toxic" by virtue of a trickle-up effect.

Experts have pointed to a $30.6 billion deal between Merrill Lynch and the Lone Star group of private equity funds as a model for the new government plan. Lone Star purchased that amount of Merrill Lynch's portfolio of asset-backed securities. Merrill Lynch reduced Lone Star's risk by financing three-quarters of the purchase. Therefore, Lone Star had limited risk, similar to how funds would have limited risk buying the bad securities with government backing. But the most important part of the deal was not Lone Star's risk; it was the price. Lone Star paid 22 cents on the dollar. This means that Merrill Lynch had priced its asset-backed assets somewhere around 22% of their original value. (Watch a video of a car dealer staying optimistic in tough times.)

Geithner hopes to encourage private investors to buy these asset-backed securities, giving the banks cash and eliminating further downside risk to their portfolios. But why not try to actually make the securities more valuable, in reality, so that investors want to buy them from the banks, without the need for government support?

Thus far, the government has focused on trickle-down solutions: dealing with complicated assets like mortgage-based securities in the hopes of stabilizing the values of more concrete assets, such as homes. In contrast, my approach addresses the root of the problem. Thus, the government would help ensure that the mortgage-based securities find a stable price via a trickle-up effect. After all, it would take an inconceivable number of foreclosures at 70% of principal to justify the assets' trading down to 22% of their face value.

This plan costs the government—and the American taxpayer—nothing but a trivial amount, the operating costs. Again, it is nowhere near as complex as what the government has done so far. It carries a small price tag compared to the massive, mostly ineffectual spending that has been the basis of the current policies. (See pictures of the global financial crisis.)

Why lower the principal of the mortgages instead of reducing the interest rate of the loan? Because it creates far more incentive for homeowners to continue mortgage payments. Moreover, with all the "exotic" loans out there, many with adjustable rates, the principal component is the only standard across all mortgages. Adjusting the remaining principal, then, is the most general way to renegotiate all mortgages as equitably as possible.

Further, there is currently a crisis of confidence in the banking world. Because of the uncertainty surrounding the future of asset values and the prices of complicated derivatives like mortgage-based securities, the banks are hoarding money. They lack trust even to lend to each other. Reducing mortgage principals addresses both of those problems directly. By stabilizing the mortgage markets, much of the uncertainty will vanish. Banks' balance sheets could stabilize. And confidence may very well return.

Implementation is the most difficult part of this proposal. While many financial institutions would immediately discount the plan, ultimately convincing them to accept it is not unreasonable. It is true that for those institutions that hold physical mortgages, their maximum potential profit will go down by the discount. For a 30% decrease in principal, the math works out to some $3 trillion potentially lost on residential mortgages, as of mid-2008, according to the Federal Reserve. But if Americans keep defaulting on these mortgages, and asset values continue to crash, the total loss to the financial world will be far greater than $3 trillion.

It is also true that the banks will probably want to discriminate: Why should they lower the principal on "good" mortgages? Why not just on those most likely to foreclose? Thanks to tranches, the "good" have been rolled together with the "bad", and specialized renegotiation is easier said than done. That is why banks have not already renegotiated loans on a large scale. But with the government's pressure, lowering the remaining principal on every mortgage could easily become a reality.

The only banks that could legitimately lose on this are those that hold nothing but "good" mortgages or tranches of "good" mortgages, with no "bad" assets. Since TARP has attracted such interest from virtually every bank, we can conclude that such "good"-mortgage banks exist only in small number.

Other advantages of this solution are that it is universal and non-discriminatory: every mortgage holder in the United States gets a break. Homeowners without mortgages also benefit, as foreclosures directly lead to deflated home values, and foreclosures will be reduced considerably. At the same time, the banks' assets will have a greater inherent value: their balance sheets will improve, and they are likely to begin loaning sooner than with the government plans.

Unlike Geithner's plan, this solution is simple and transparent. It does not require the government to price complicated derivatives. It requires only one decision: by what uniform percentage to reduce mortgages. And unlike all of the other plans out there, it does not require significant government spending. It is also politically palatable, as it does not discriminate and does not rescue certain institutions over others. Homeowners get the most direct benefit, and the solution is efficient because of its flat-tax-like nature. Just about everybody wins.