H.O.M.E. (Home Owners’ Mortgage Enterprise): Nouriel Roubini Solution

Real solution for our troubling times.  Unfortunately present Bush had some bullshit plan with his comrades Bernake & Paulson today…expect more shit hitting the fan and the mess coming our way.

I wish the people were in charge on our country, you know a real democracy.  I’m afraid this is going to be long and painful economy to come.

---

http://www.rgemonitor.com/roubini-monitor/253653/we_need_a_new_holc_-_more_than_a_new_rtc_or_rfc-_to_provide_massive_debt_relief_to_the_household_sector_we_need_to_create_the_home_home_owners_mortgage_enterprise

We need a new HOLC – more than a new RTC or RFC- to provide massive debt relief to the household sector. We need to create the HOME (Home Owners’ Mortgage Enterprise)
Nouriel Roubini | Sep 19, 2008

In the last two weeks financial markets reached near panic conditions with almost every day another major financial institution on the verge of collapse (first Fannie and Freddie, then Lehman, then Merrill, then AIG and now Morgan Stanley, Goldman Sachs, WaMu, Wachovia and other banks under pressure), money markets seizing up and interbank spreads spiking like never before, Treasury bills yields plummeting as investors were seeking the safety of near cash instruments, credit spreads surging and stock markets tumbling on Monday and Wednesday. Even the Washington policy makers finally realized that this is the worst financial crisis since the Great Depression and that their ad hoc step-by-step and unsystematic approach to resolving this crisis was not working and the effect of ad hoc and band-aid policies in boosting market confidence was fizzling out. Indeed , after the March bailout of Bear Stearns markets rallied for two months; after the July announcement that Fannie and Freddie may be rescued markets rallied for three weeks; after the announcement of the actual bailout of Fannie and Freddie last week markets rallied for only one day on Monday and went into a tailspin starting on Tuesday with the worries about Lehman and other broker dealers; and after the bailout of AIG stock markets did not even rally: actually they tumbled almost 5% on Wednesday while money markets and credit markets went into a total seizure.

So by Wednesday this week as markets were in total panic (stock prices collapsing, interbank spread surging to levels never seen before, credit spreads reaching new highs and Treasury bill rates practically down to zero as investors rushed to safety) the policy authorities decided that something more radical – that many of us had advocated for a long time – needed to be done. The most important policy action is not the decision of extending the swap lines between central banks (so as to provide dollar liquidity to non-US banks abroad); it is not the re-imposition of limits to short sales (a policy action that is itself a naked attempt to manipulate upward stock prices); it is rather the realization that a generalized debt and solvency problem required a solution that leads to significant debt reduction.

Let me explain in detail how we now need bold policy action to resolve this most severe financial and economic crisis…

Households in the US have too much debt (subprime, near prime, prime mortgages, home equity loans, credit cards, auto loans and student loans) while their assets (values of their homes and stocks) are plunging leading to a sharp fall in their net worth. And households are getting buried under this mountain of mounting debt and rising debt servicing burdens. Thus, a fraction of the household sector – as well as a fraction of the financial sector and a fraction of the corporate sector and of the local government sector – is insolvent and needs debt relief.

When a country (say Russia, Ecuador or Argentina) has too much debt and is insolvent it defaults and gets debt reduction and is then able to resume fast growth; when a firm is distressed with excessive debt it goes into bankruptcy court and gets debt relief that allows it to resume investment, production and growth; when a household is financially distressed it also needs debt relief to be able to have more discretionary income to spend. So any unsustainable debt problem requires debt reduction. The lack of debt relief to the distressed households is the reason why this financial crisis is becoming more severe and the economic recession – with a sharp fall now in real consumption spending – now worsening. The fiscal actions taken so far (income relief to households via tax rebates) and bailouts of distressed financial institutions (Bear Stearns creditors’ bailout, Fannie and Freddie and AIG) do not resolve the fundamental debt problem for two reasons. First, you cannot grow yourself out of a debt problem: when debt to disposable income is too high increasing the denominator with tax rebates is ineffective and only temporary; i.e. you need to reduce the nominator (the debt). Second, rescuing distressed institutions without reducing the debt problem of the borrowers does not resolve the fundamental insolvency of the debtor that limits its ability to consume and spend and thus drags the economy into a more severe economic contraction.

So of the five possible uses of fiscal policy – income relief to households (the 2008 tax rebate), rescue/bailout of financial institutions (Bears Stearns, Fannie and Freddie, AIG), purchase of assets of failed institutions (an RTC-like institution), recapitalization of undercapitalized financial institutions (an RFC-like institution), government purchase of distressed mortgages to provide debt relief to households (an HOLC-like institution) – the last option is the most important and effective to resolve this severe financial and economic crisis. During the Great Depression the Home Owners’ Loan Corporation was create to buy mortgages from bank at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed rate mortgage rates. This massive program allowed millions of households to avoid losing their homes and ending up in foreclosure. The HOLC bought mortgages for two year and managed such assets for 18 year at a relatively low fiscal cost (as the assets were bought at a discount and reducing the face value of the mortgages allowed home owners to avoid defaulting on the refinanced mortgages). A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced; thus it will be the macro equivalent of the “bad bank” that Lehman tried to create for its bad assets.

Creating a new HOLC mechanism is likely to be more effective than creating a new RTC (whose purpose was to buy and dispose over a number of years of the assets of already failed S&Ls): we need to provide debt reduction to households well before hundreds of banks failed as working out the bad assets only after banks have failed is costly. Certainly many insolvent banks will fail regardless of in this financial crisis; and once they do their bad assets can be transferred to the new HOLC to be rapidly worked out. But we don’t need an RTC that picks up the bad assets of failed banks and works them out after such banks have failed; the priority is to take off the balance sheet of distressed and/or potentially insolvent banks the bad assets and reduce their face value so as to avoid a tsunami of defaults, foreclosures and/or households walking away from their homes. Similarly having an HOLC is more important than creating an RFC (the institution that during the Great Depression injected public capital – in the form of preferred shares – into 4000 undercapitalized banks).

An RFC mechanism may be necessary once an HOLC is created: purchasing mortgages at a discount implies banks taking an additional capital hit (if they have not already written down the value of such assets or have not provisioned for the loss with loan loss reserves); therefore the purchase of such assets will further undercapitalize such institutions that do need more capital. So the government injection of capital with preferred shares will allow distressed but solvent banks to increase their capital and thus not to be forced to contract further credit as it would be the case if they remain undercapitalized. One way to combine an HOLC model with an RFC model would be having the government injecting preferred shares in banks in exchange for their willingness to work out the mortgages and provide debt relief to distressed homeowners. But combining an HOLC with a RFC may be messy as the government would have to have a real strong power to induce banks to reduce the face value of mortgages to a level that homeowners can afford. Thus an RFC with HOLC components may not work for the same reason why the Frank-Dodd bill (that gives an FHA guarantee to mortgage that have been voluntarily reduced by banks) is not likely to work: unless you force bank to do sufficient debt reduction they will delay such action or do only cosmetic refinancing that don’t reduce unsusgtainable debt burdens for households. It may thus be better to create an HOLC that works out the debt and separately inject capital – a la RFC – into distressed but solvent institutions. And of course – RTC style – the bad mortgage assets of failed institutions (as indeed many insolvent banks will fail) – would also be transferred into the new HOLC to be worked out (providing debt reduction for distressed homeowners).

Do we need to create a new institution (an HOLC or, a better, and new/catchy term such as HOME (Home Owners’ Mortgage Enterprise) or can we use in the interim – while legislation is passed and implemented – existing institutions such as Fannie and Freddie (F&F) and the FHA to do the debt workouts? Using F&F and the FHA may be a good stop gap measure in the short run and such institutions have the skills and expertise to work out mortgages. But over time a new institution fully devoted to the task is necessary as saddling the already insolvent F&F with more bad assets to be worked out may not be the best way to restore the long term viability of such GSE institutions that – in due time – need to be cleaned up, broken up in smaller pieces that are not systemically fragile and sold back to the private sector.

How to minimize the moral hazard of this massive government bailout of financial institutions and distressed borrowers? First of all let me be clear as many will scream that this HOME program would be the mother of all bailouts: every financial crisis and banking crisis is resolved with some government intervention (not by markets) and such government intervention has a significant fiscal cost; that is unavoidable as the alternative – a disorderly “market” workout – would end up being more costly for the government as 1000s of banks would go bankrupt and – given deposit insurance –the fiscal cost would be much larger than the one in an orderly workout. So either way there will be a fiscal “bailout” in every banking crisis: the only issue is how to make it less costly, more fair and less inductive of moral hazard.

To avoid a situation where homeowners who don’t deserve debt reduction take advantage of this new HOME facility one can make the program mean-tested (only homeowners below a certain income level will get relief) and also restrict it to first time homeowners; so sorry you folks – condo flippers, second home owners, vacation home owners and speculative gamblers – who bought homes with no down payment and are now into negative equity; you will not get debt relief. And those home owners who are so distressed that would not be able to service their mortgages even at a level equal to the lower market price of the home and with a fixed rate (rather than variable rate) mortgage should be forced into foreclosure and move into rentals; not everyone can afford – ever after debt relief – to be a home owner.

In the case of banks – to avoid moral hazard and limit the fiscal costs – you need to limit the risk that the government overpays for the bad assets that it buys from banks and mortgage lenders. An auction system may work in principle but in practice may be flawed as different bundles of mortgages have very different credit risk and the banks know more about their riskiness than the government does; thus, you risk having banks dumping at an inflated price (too low of a discount) their worst assets into the government HOLC (or HOME). Strict rules will have to be used to avoid having the government overpaying for such assets. And similar triage rules will have to be used to decide which institutions are distressed and illiquid but solvent once they have more capital and thus deserve getting public capital (preferred shares) to continue to operate and create credit and which ones are insolvent and need to be closed/merged as in the case of insolvent banks putting more public capital would be a waste of public resources and would not resolve their fundamental insolvency. Also the new preferred shares of the government should be senior to common share and other preferred shares (and carry a high enough dividend) and should also be senior relative to all of the other creditors of the bank (with the exception of insured deposits); thus, no more of the bailout of unsecured and sub-debt creditors that occurred in the case of Fannie and Freddie. Sub-debt holders of banks (and creditors other than insured deposits) should be appropriately whacked if needed to ensure market discipline and avoid future moral hazard.

Many details of this new HOLC – or HOME – will need to be figured out but rapid legislative action is urgent; if legislation is not passed in the next few weeks Congress goes into recess and does not return until next February when the new president is elected; then if legislation is passed only next spring it may too late to avoid a financial disaster: by then home prices will be 10% lower (and they have already fallen 25%), millions of more homeowners will be in foreclosure or will have walked out of their homes. To avoid a disorderly meltdown of the housing and mortgage market action should be taken now. Some of us pushed for debt reduction solutions for over a year now; but policy makers were busy pretending that this was a minor problem and that minor band-aids (such as the HOPE plan to freeze mortgage resets) would be enough. When there is a debt problem you need across the board debt reduction (not a useless, partial and voluntary freeze of debt servicing payments). Over a year has been wasted playing with minor and ineffective programs while the perfect storm of the century was battering financial markets and the economy.

At this point a severe recession is unavoidable; the only question is how severe and protracted it will be. Debt reduction and public recapitalization of banks will not instantly resolve every problem and will not prevent a painful recession that – at this point – will last at least 18 month. But it will prevent a painful U-shaped recession from turning into a multi-year L-shaped recession like the one that afflicted Japan for a decade after the bursting of its real estate and equity bubble. So let us not delude ourselves that even a HOME program of debt reduction will prevent a recession: the recession train has already left the station and the economic downturn is already becoming global. What we can avoid now is only the risk that a severe US and now advanced economy recession will turn into a Japanese style decade long stagnation. Thus, the time of dithering and using band-aid to deal with the financial storm of the century is over and the time to act boldly is now! Lets create the HOME (Home Owners’ Mortgage Enterprise) now!