Plan To Resolve the Root of the Economic Crisis Efficiently by Ian Christian Wulff This financial crisis could end with less than 2% of the $7 trillion committed, and it’s easy to prove. Below is an efficient, logical solution, with mathematical and graphic illustration. If it infuriates you as it has others, please contact your representative (see www.congress.org), refer them to “STOP THE LEAKS” plan on this site, and ask why we’re spending $7 trillion.
AN EFFICIENT ALTERNATIVE TO BAIL OUT EFFORTS by I. Christian Wulff
This economic crisis could end with less than two percent of what has been committed, proven with simple math and irrefutable logic. To begin, it should be obvious that NONE of the financial disturbance from mortgages would have occurred, had virtually all of those payments been kept current, and the housing market would not have so collapsed had there been no foreclosures. That could be realized, but at what cost? There were about four million foreclosures in the last three years. Had we intercepted those defaults before foreclosure, and offered a deferral of one-third of each borrower’s payments for five years, that sum would be $120 billion. But this only demonstrates the comparison (2% of 7 trillion committed) with easy math to make the point. With details, it shrinks to probably less than $10 billion a year for four years. And all, or most, of that would be paid back. That comparison is shocking, but the abundance of errors by Treasury makes the current affair more outrageous.
Treasury has failed to recognize critical dynamics of this crisis. The most obvious and inexcusable is that nothing is as effective as keeping payment streams intact. Efforts made so far are focused on integrity of financial institutions, which is only one consequence of foreclosures. It misses the cause, which is foreclosures, so all consequences continue (see illustration: Leaking Pipes). Secretary Paulson has also failed to address the feedback loop between foreclosures and a declining the real estate market. More foreclosures bring down prices (by increasing supply and scaring away demand), and declining prices cause more foreclosures (as more borrowers end up “under water” from declining prices). Furthermore, compressing any sum of foreclosures into a tight time frame compounds damage greater than a distribution of the same sum over a much greater time span. And that assumes that the sum would be the same, given time. Taken with the above, it would probably be less. Therefore, any measure that extends the distribution of a surge of foreclosures is likely to reduce the number, and the damage. Paulson fails to recognize any economic effects outside financial institutions, so much so that he ultimately fails institutions themselves. Foremost in that, is an efficiency in keeping homeowners engaged. Foreclosure, when compounded by multiples, incurs enormous cost. The direct and indirect investors lose all of the payment stream. Any compensating or remaining value is diminished by costs to remove the occupant, repair the property, and find a purchaser. The purchase price will be low in such a market, and it may be slow in coming, creating carrying costs. The neighborhood will bear the burden of decline, and the community will achieve lower tax revenues and suffer greater demands on services. Individuals will suffer losses that will translate into diminished purchasing and ultimately fewer jobs. But, when the homeowner remains in the home, he or she continues to make payments, maintain the property, pay taxes, and in effect, sustain the market by avoiding the burden of another vacant home. And, all of the chain of damaging effects listed above are avoided, too. If it requires an expenditure to carry a minor part of that borrower’s payment for a number of months, that cost pales in comparison to those losses enumerated. Moreover, one has to wonder how banks could manage to lose far beyond the initial investment in bad loans. Even if they lost total principal in those four million loans foreclosed, at a median home value of roughly $250,000, financed at 100%, the loss would be one trillion dollars. Yet, we’ve had to issue or commit seven times that, and the loss continues. We need an industry that handles money that poorly, like we need Osama bin Ladin managing our airlines?
The opening proposal (defer partial payments on existing loans) is simple to make a point, but the efficiency could be improved by paying off those loans, and refinancing. In addition, it seems fair and feasible to require banks to cover the cost to discount those refinanced loans by one percentage point below market. That expense would be small compared to the cost and damage imposed by a foreclosure. Those measures would bring the payment on the loan down by more than half of the deferral suggested. The minor remainder of that reduction would be born by the government (i.e. less than half of the $500 deferral stated above).
But this is only a deferral, not a subsidy. The borrower would be expected to pay it back and the features described here make that likely. The combination of payments and interest rate prescribed, would yield a mortgage balance in five years that leaves real equity in the home. That is a presumptive statement, but it assumes price appreciation over the long term that matches a historical average of about four percent. With foreclosures off the market, and a recovery of the economy over that term, such a modest rebound is a conservative expectation. Most borrowers would avoid foreclosure, but only if the plan is broad enough to involve everyone at risk. Current efforts are so weak, that most foreclosures proceed, further damaging the market and the economy, so that even those rescued may still end up under water as prices continue to decline.
With most borrowers paying back deferred payments, the cost of such a program would have no net cost. But even if none of that is paid back, the cost of such deferrals would be between ten to twenty billion dollars a year for a few years, and any persistent foreclosures would be scattered across an extended term, dampening the compounded pressure from foreclosures which is currently killing home values (details of the plan intentionally scatter persistent foreclosures). In other words, even if the program fails, it would cost a fraction of one percent, as compared to the catastrophic costs of failure and expense of the current plan.
Following details outline the plan. An example demonstrates numeric events, and subsequent charts map it out, along with other supporting features. Refer to them if you want substantiation. Otherwise, avoid the complication. The summary of Key Features of the plan might be handy, and there is also a graphic titled “Leaking Pipes” to illustrate errors of current efforts by Treasury, and why those efforts will fail.
Key features of the plan. All needed, to work in concert: – reduce troubled borrowers’ payments low enough to allow recovery – five-year term gives plenty of time for borrowers to repair or recover personal finances – removes foreclosures from the market to allow return to normal inventory levels – normal inventory allows the real estate market rebound, and… – only modest appreciation (at historic long term appreciation rate) brings values higher than mortgage balances (with accumulated deferred interest) by the time borrower needs to sell or refinance – leaves borrowers in homes, with incentive to continue payments, maintain property, and pay property taxes – pays lenders the balance of troubled loans (with minimal discount) – payment support on refinances nearly insures lenders payment continuity – persistent foreclosures are minimized and scattered over a long term (avoiding the competition from selling many at once, which brings down prices) – downward pressure on home prices is relieved by removal of foreclosures – eliminates bank losses from foreclosures – removes risk of failed income streams from all bad mortgages, for all derivative participants – government (taxpayer) carrying cost is relatively small and spread over years (less than $10 billion/yr) – government costs are likely to be paid back The plan is calibrated to achieve all these effects, and all effects are necessary to make it work. The program would be incapacitated by omitting any, for example: changing loan terms might yield a future loan balance that wouldn’t achieve positive equity in time, or stopping only some foreclosures wouldn’t produce conditions to turn the real estate market around and avoid associated bank losses. The plan is designed with all parts working together.
LEAKING PIPES WON’T KEEP A TANK FILLED
Imagine a plumbing system, which begins with a Reservoir of all resources that have some monetary measure, present and future. Those resources flow out, with part going to relatively immediate consumption and production. Another part goes into a Reserve from which we hold, manage and distribute resources for the present time frame. That gets fed back into the stream of resources used for consumption and production. This Reserve tank which collects, and then redistributes, resources is our financial system. Presently, the Feed line from the Reservoir, is leaking. That affects the current supply for consumption and production, but it also limits flow into the Reserve tank, which is also leaking.
Explanation for diagram right above here: Recent measures to resolve disruption from those leaks, have focused on the Reserve tank, trying to keep it filled, so that it can continue to release resources into the Supply line. This is being done by diverting additional resources from the Reservoir in two ways: (A) taking from future resources, in what we realize as borrowing against future tax revenue, and (B) siphoning from Current Supply, which we feel in cutbacks and economic contraction. But, at the same time, the Distribution Line has been moved higher (C), as banks hoard capital, fearing depletion. So now, even though the Reserve tank may be filling, it is not emptying into the Supply line. This effort also fails to recognize the expense of withdrawals required to fill the tank, and it ignores the leaks (primarily, foreclosures). Not only are leaks still there, but they are increasing in size and number. So, despite efforts to refill the Reserve tank, the Supply line is suffering even worse than it was before. Only the holder of the Reserve tank feels anything is improving, but continually more and more resources are required to fill the leaking tank, and it becomes harder to fill as the Feed line leaks more. The effort will ultimately fail.
Example and Details Here is a sample scenario to demonstrate an efficient application of the concept described. First, imagine a house, worth about $175,000 four years ago. The boom brought that price up at 20% appreciation in each of two years, so the price when the borrower bought it was $250,000. Two years later, brings us to today, and the value is now $200,000. (Were it to have gone that low with 4 million foreclosures averted, could be argued. But let us assume that value, because that is where we are.) The borrower initially financed the full $250,000 price at purchase with an interest rate of 7 percent. Amortized at that rate, payments would be 1663/month, and the balance would now be about $245,000. The borrow can not now handle that payment. Instead of foreclosing, current investors receive full payment on the balance, minus a discount fee described ahead, and a new mortgage replaces it with the nearly the same balance (minimal added for administration). The new loan is made at a rate 1 percentage point below current market, and the borrower can defer one-third of the mortgage payment for five years. The initial investors are paid off, minus a discount fee to adjust the rate on the new loan (paid to the new lender, if new loan is not made by the original lender). Still, that penalty is nothing compared to a lender’s losses and complications of foreclosure. The deferred portion of the payment is provided by the government plan, so the lender receives full payments at the new rate. The borrower can now stay in the home and continue with lower payments, but in five years must pay the deferred amount. (The plan should offer a refinance program to cover that, which should be pre-committed, subject to conditions.) In five years, the balance of the loan will be about $242,000. That means the property needs only appreciate at about 3.8 percent annually over five years to reach a positive equity position. That is a reasonable expectation, given that foreclosures will have been averted almost entirely during that time, and that breakeven price is still about the same rate of appreciation (3.9%) from the $175,000 value of four years before the five year deferral period (nine years total). The net effect in appreciation would be as if no boom or bust had occurred, so long as disposition of the property had remained unchanged. This outlines the effects. The chart provided gives more detail and a better view of the relationships.
Of course, there would not be four million defaulting borrowers applying for this program on the first day, so the effect would not appear as the simple math formula initially demonstrated. Application would likely be high at the beginning, and then taper down as recovery heals the market. So, you might get 2 million in the first year, then maybe a million plus in the second, and less still in the third. I’d bet on a faster recovery, with foreclosures halted. Then, toward the end, but not necessarily all at once, payback of deferred sums would come. Somewhere in the middle there would probably be some payback offsetting some deferrals.
In addition to the outlay for support of payment deferrals, there will likely be some losses from borrowers who will not take advantage of the deferral program, for whatever reason. Submitted also is a plan to dispose of those properties in a way that recoups losses and provides incentives for a new buyer to opt for such a purchase. The key to that plan is a zero percent interest rate for five years, but other features modulate its efficiency. Losses incurred in that plan are also periodic, with an average monthly loss in the range of $300 per month (due to subsidizing the interest rate). There is a chart of that example, also. Finally, there is a chart showing an example of how these cash flow events might play out, using sample volumes, just to illustrate the distribution and net effect of outlays and payback over time. Notice that the net outlay in any year is likely to be less than $10 billion. Incidentally, recognize also, that with losses that small, the industry should have been able to manage it without taxpayer help at all.
One other feature is necessary. There must be a way to avoid having all of these salvaged mortgages ending up back in the same position as they presently are, and all at the same time. We don’t want millions of homeowners faced with a choice between payments they cannot afford (when the special payment term ends) and selling their homes, all at once. If borrowers cannot recover financially in the time allowed, or markets do not recover adequately, or other economic conditions interfere, and default results after all, these must not occur all in a short time frame. Any foreclosures that result, should be distributed over a long term, to avoid a compounding effect that multiple foreclosures can have on a market. Most dangerous, are initial terms that produce very low monthly payments, however low payments are probably necessary to keep many borrowers participating. The program should probably gauge payments to borrowers’ circumstances to avoid going lower than needed, according to a borrower’s capacity. In addition to guidelines for adjusting payment levels, there might also be adjustment for term, also according to borrower capacity or circumstances. Bureaucratic guidelines often fail to address unforeseen conditions, resulting in some improper determinations, so these should be simple and not too dramatic. Better than too many imposed guidelines, would be an incentive-driven approach for adjusting the term of payment deferrals. The program should offer a range of interest rate reduction based upon the term a borrower chooses. A shorter term would get a lower interest rate, and longer terms would get less of a reduction. The incentive should adjust the length of the term, but not the payment. The purpose is to distribute terminals over a vast time frame. That way, any borrowers who ultimately fail will be less likely to be tripping over others in the same position, if they need to sell their houses to get out.
The full plan should attempt to make it feasible for borrowers to ultimately succeed in keeping their homes even beyond the deferral term. It should distribute the few failures over a very long term so that most foreclosures can be avoided by selling, but not so they would be competing with many others. By minimizing foreclosures in numbers, and distributing those that do occur over an extended period, any remaining foreclosures are likely to be soaked up by speculators, as the count should be small in any given market inventory. Obviously, the cash flow chart given here does not account for all of these variations and adjustments. It is provided, however, to illustrate an average distribution of outlay and returns, at least to give a sense of the likely range. Any more detailed analysis would be even more speculative and complicated. Since the adjustments proposed should be either within the terms presented for that chart, or within a range averaging the same, the conclusions should be reasonably consistent.
Notes: The plan could work by keeping current loans intact (i.e without pay off and refinance), but re-amortization and current market rate (as done in this demonstration) adds to efficiency enough to cut deferral costs in half.
Homeowners who need to relocate (and thus, to sell their “under water” home) might also be served by creating a means to transfer their mortgage deficiency from a sale, onto the mortgage for the new home, using the same mechanisms described in this plan.
In anticipation of complaints about assisting irresponsible borrowers, note that the greater concern now is avoiding national ruin.
