A Mortgage Guarantee Program Could Utilize Positive Multipliers to Overcome the Downward Spiral of Economic Events
By Martin Lowy
Reports suggest that although the Chairman of the FDIC is advocating that the U.S. Government offer to guarantee mortgages that meet specified criteria after being modified, the Treasury Department opposes such a step. That is potentially tragic because a mortgage guarantee program could have a positive multiplier effect that could counteract the negative feedback loop that the losses at and consequent de-leveraging of financial firms have caused. A mortgage guarantee program could restart the world’s financial engines. Perhaps President-Elect Obama’s team will see that.
The guarantee program would offer lenders (for a period of months) the opportunity to opt for a government guarantee of a percentage of the original appraised value of the mortgaged home if the lender agreed to reduce the interest rate on the loan and modified the loan in other ways to bring it into conformity with best practices. As an example, the Government could offer to guarantee 75% of the original appraised value of any first mortgage on a single-family home in exchange for reducing the interest rate on the mortgage to a fixed rate that is a small number of basis points over the 10-year U.S. Treasury rate. The lender also would have to waive any penalties previously imposed. These specifics would put a floor under the value of all U.S. mortgages while at the same time permitting hundreds of thousands of borrowers to meet their payments or meet them more easily. A period of four months ought to be sufficient for all lenders and servicers to decide which mortgages to put into the program.
It is important to make the lenders or servicers the decision-makers, after giving them incentives, because borrowers, sensibly, will always opt for better terms, regardless of whether they need them. It also is necessary, in order to put a floor under the mortgage market, that the amount the government would guarantee be based on a number that is known to the market in advance. The original appraised value is such a number. And even though a percentage of that number, such as 75%, is known to be lower than the amounts of many first mortgage loans in markets where the value of homes has decreased by 40% or more, the risks of government losses are more than balanced by the overall benefits of a uniform program that can restart the world’s financial engines.
The market would know that almost any mortgage loan, regardless of whether its owner had accepted the Government’s guarantee offer, was worth at least 75% of the appraised value of the property at the time the loan was made. This market knowledge would permit mortgage-related securities to be re-rated and traded with confidence for the first time since early 2007.
It also would be optimal to make clear, by regulation or, if necessary, by legislation, that servicers for loans that have been securitized may satisfy their obligations to security holders by making a good faith determination that their actions will maximize the overall value of the loans, without regard to the impact of such actions on the values of individual tranches into which the loans may have been divided.
Regulation or legislation regarding second liens also might be desirable to reduce the burdens on affected homeowners and to protect the Government from homeowners having to make payments on second mortgages that have no economic value. Payments to second lien holders (who would not have reduced the interest rates they charged) might well reduce the homeowners’ long-term ability to pay the first mortgages that the Government has guaranteed.
Over all, the program would be designed to positively affect the value of the mortgages and borrowers’ ability to pay, not the value of the underlying real estate that, except for indirect effects, would be allowed to find its market level.
This program might be costly. I cannot make a good estimate of what it would cost. But the cost almost does not matter because numerous multipliers would leverage the benefits. I have counted 12 multipliers but probably there would be even more.
Discussion of the Program’s Benefits to and Through Financial Institutions
The basic benefit is to the holders of the mortgages or securities that comprise pieces of mortgages. That benefit would be greater than the cost, whatever it is, because it would affect not only the mortgages actually guaranteed, but also, by implication, all other mortgages. Thus, without any other multipliers, the benefits (to someone) must outweigh the costs, unless the structure of the program increases losses by creating moral hazard. (The moral hazard issues will be discussed below.)
Would the benefits to society outweigh the costs? Because of all the multipliers, the answer is yes.
The benefits to the various institutions holding the mortgages would bolster their balance sheets. Their assets would become more liquid and their real capital would increase. Those benefits would make banks all over the world more willing to lend, since lack of capital and lack of liquidity are the two largest factors that currently inhibit loan activity. Real capital is the multiplier for lending, since a bank can make loans that are about ten times their capital. Thus, increasing real capital, as placing a floor under the mortgage market would do, would permit banks to make loans of ten times the amount of capital gained.
But there is another multiplier for the holders of mortgage-related securities: The investment banks created not only securities composed of pieces of mortgages, they also created securities based on “synthetic” pieces of mortgages that mimic the market values of the real pieces of mortgages. If the value of the real pieces of mortgages is raised, the value of the synthetic mortgages also will be raised.
Raising the value of mortgages and mortgage-related securities also will reduce the losses that banks and other institutions will suffer (or have suffered), which leads to increased tax revenues at approximately a 35% rate. (By contrast, when the Government invests capital in a bank, that investment results in no increased tax payments by the bank, except in the longer term if the capital is used to successfully leverage earning assets.)
The Government also has guaranteed loans and securities on the books of Bear Stearns, AIG and Washington Mutual, in addition to investments in, guarantees and implied guarantees of Fannie and Freddie. The mortgage guarantee program will bring value to those investments and reduce the costs of those guarantees.
Bolstering bank balance sheets would increase the value of the capital investments the Treasury has made in banks.
In addition, raising the values of mortgages would tend to lift the ratings of bond and mortgage guarantors, which, even more beneficial, would raise the values of the bonds and securities that they insure. Amazingly, that set of multipliers would lead to more benefits, as municipalities, pension funds, life insurance companies and other institutions that benefit from bond insurance would find their asset values increased. Companies whose pension funds’ values increased would have to contribute less to those funds, thereby increasing their profits and decreasing their need to lay off workers.
Those are the benefits for and through banks and other institutions. They would be sufficient to make the program valuable. But the benefits to the economy as a whole and individuals and communities could be even greater.
Benefits to Borrowers, Communities and the Economy
Individual homeowners whose mortgages were restructured obviously would benefit. Some of them would be enabled to keep their homes. Others would be able to make their payments more easily—and they likely would spend their savings, thus providing a stimulus to the economy that is free of cost to the Government because we already have accounted for the cost to the Government above.
Keeping people in their homes and avoiding foreclosures also benefits everyone who lives in the affected communities, since tax payments continue, lawns are better kept, and the fabric of local society is less rent.
But the biggest dividend from the program is yet to be discussed: The change in global psychology. All the myriad programs that governments have instituted have targeted specific types of financial institutions or specific mortgages. This program would go to the heart of the cause of the crisis—the value of all U.S. mortgages and mortgage-related securities. Downward cycles are products of psychological effects, just as the boom or bubble was the product of psychological effects. And just as economic forces acted to encourage the boom or bubble, economic forces act to encourage the psychology of the downward spiral. This program would break that downwards psychology by making banks willing to lend, by keeping people in their homes, and by raising the value of assets.
A better psychology of course leads to greater economic activity, which leads to more tax revenues. Maybe the government would have no net cost at all. Maybe there would be a significant net gain for the Government as well as the people. There is no free lunch; but sound investments, even by governments, can earn good returns.
To recapitulate, the benefits are:
- Raising the value of all U.S. mortgages and mortgage-related securities.
- Increasing the real capital and liquidity of banks, thus permitting and encouraging them to lend.
- Increasing the value of synthetic mortgage-related securities.
- Generating tax revenues from banks and other institutions.
- Reducing the cost of the Bear Stearns, AIG, Washington Mutual, Fannie and Freddie guarantees.
- Enhancing the values of the capital investments the Treasury has made in banks.
- Raising the ratings of bond and mortgage insurers, which in turn benefits the many types of institutions that use their guarantees.
- Keeping people in their homes and avoiding foreclosures.
- Generating the stimulus of consumer spending.
- Preventing communities from foundering as foreclosures reduce tax revenues and cause social disruption.
- Reversing the global psychology of the downward spiral.
- Generating tax revenues from increased economic activity.
With all these benefits, where is the downside?
The possible downside generally might be placed under headings of “moral hazard” and “unintended consequences.” Every government program has unintended consequences and risks creating moral hazard. That does not mean that government should never act. But it does mean that the unintended consequences should be studied—and if they can be foreseen, designed around.
The principal forms of unintended consequences that one might foresee are: (1) Long-term moral hazard, (2) Losses incurred by those that are short mortgage-related securities, (3) Increased levels of non-payment on mortgages as homeowners jockey to obtain reduced rates, (4) Government absorption of losses on mortgages that already are too far gone to benefit from the restructuring, (5) Lenders might put mortgages into the program just as a safety net, thereby increasing the size of the guarantees unnecessarily, (6) Government-guaranteed investments can tend to drive out private investments.
- Long-term moral hazard. The process of decay and the downward spiral have gone on long enough and the situation is extreme enough that long-term moral hazard should not be a significant issue. A bailout at this stage will not tend to encourage future risk-taking any more than dozens of other things that governments have done to cushion the impact of the losses.
- The shorts. It is true that those who are short mortgage-related securities would suffer losses. I do not know who those parties would be or what would be the size of their losses. I would guess they are hedge funds and I would observe that they know quite well that government action is likely to influence the value of their mortgage-related securities bets. Are any of these funds so large as to pose a risk? I do not know.
- Increased levels of non-payment. Many reports suggest that borrowers are well aware that they may get reduced terms under certain circumstances. And many lenders and servicers have taken the position that they will not reduce the terms for any borrower that can afford to make the payments. This has caused many borrowers to threaten to stop making payments or in fact to stop making payments. The proposed program should not make this problem worse because it has no requirement that the borrower be in arrears or be unable to make payments. All the proposed program requires is for the lender or servicer to make a judgment that the guarantee is worth the interest rate reduction and other changes in terms. That is, the lender or servicer has to decide that the value of the mortgage will be greater after the changes than it was before them. Some lenders or servicers might choose to test borrowers by requiring that they be in arrears before accepting the government’s offer—and their doing that might increase the government’s cost. But that cost increase does not seem likely to be significant.
- Far gone mortgages. Under the proposal, the Government would incur losses on some mortgages that are far-gone and could not be rescued by changes in interest rates. That simply is one of the costs of a program that is bold enough to change the prevailing psychology that feeds the downward spiral.
- Overuse of the facility. Overuse of the facility probably should not be a big worry. But it can be protected against by requiring that a lender agree to sell the mortgage to the Government at any time in the next five years for the amount of the guarantee.
- Government-guaranteed investments can tend to drive out private investments. The problem of government-guaranteed investments driving out non-guaranteed investments has been observed in the interbank market and the commercial paper market as central banks have tried to restart the frozen money markets. It is a real problem that should be avoided if at all possible. I do not believe that the proposed program would incur this form of moral hazard because it is a one-time guarantee only of old loans and it is a partial guarantee. But it is worth worrying about this issue in designing the details.
I welcome others to worry about other forms of unintended consequences and to help design around them.
It is not yet too late to spend Government money wisely. The available multipliers for placing a floor under the values of mortgages and mortgage-related securities are far greater than the multipliers that might be put into play by fiscal stimulus or additional direct contributions to the capital of banks or other firms.
Lack of Capital, Not Illiquidity, Kills Banks
Almost all the heroic efforts of the U.S. Federal Reserve, U.S. Treasury and various European governments to save the international banking system have been aimed at restoring liquidity to the banking system and money markets. The recent injections of capital into banks are a departure from the emphasis on liquidity and a welcome one. My own guess, however, is that the amounts of capital being injected will not be sufficient, given the market’s doubts about the values at which assets are carried on bank balance sheets. More capital will be needed unless the banks’ balance sheets can achieve a higher level of trust.
Liquidity is essential for banks and money markets to function. But in fact, liquidity (or lack of liquidity) turns out to be a product of the market’s confidence (or lack of confidence) in balance sheets and the capital levels they show.
How do we know that illiquidity is a symptom rather than a cause? Because in modern times no U.S. bank has failed because of a liquidity crisis that was not caused by the market’s belief that the bank lacked capital. I have studied all the major bank failures since World War II. In every single case, a lack of capital or the market’s doubt about adequate capital caused the failure, even if a run was what caused the authorities to step in.
Why is this important? It is important because it teaches us that efforts to restore liquidity, however heroic, will not succeed unless the market comes to believe in a bank’s balance sheet and the capital it purports to reflect.