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Jeffrey Ely's mortgage proposal
We all need more creative thinking and Jeff is one of the best people to supply it:
True just sending money is not incentive compatible. But there is no reason to bail out homeowners. Just intervene in any mortgage default. Seize the property and continue making the mortgage payments. In the short run rent the property back to the homeowner.
This is what I have been advocating to my colleagues. I don't know why it is not under discussion. Before going with the arbitrary implememtation that Paulson is proposing now there should be some convincing argument that it's more efficient than this alternative. It is clearly the most direct approach and therefore should be the default (so to speak.)
Thoughts? Unlike Tyler (and some others), Jeff is not obsessed with Jonathan Swift.
Posted by Tyler Cowen on September 24, 2008 at 03:03 PM in Economics | Permalink
Comments
Or let returning veterans live in them rent-free.
Posted by: Jim Hu at Sep 24, 2008 3:07:46 PM
Interesting. I'd like to throw in one more ingredient to a solution which would help with the moral hazard problem. Randomization. If we really just need to save half of the homeowners from foreclosure to unclog the plumbing, then let's just save half. Randomly. Make it a lottery, and make it just as expensive to enter as it is now, i.e. personal financial ruin. I like Jeff's execution mechanism the best of all I've seen.
Posted by: BoscoH at Sep 24, 2008 3:13:55 PM
The Treasury Department has (or can hire) the expertise to buy and hold $700 billion of securities. The Treasury Department does not have, or know where the find, the expertise to own, manage and rent 3 million houses.
Posted by: y81 at Sep 24, 2008 3:15:10 PM
This is no longer about housing. Settling the uncertainty around securitized mortages will take years even with a Gov't bailout. The banking problem ( if you believe it) is happening now. We need to address the
liquidity/solvency issues not to continue to redirect money to the housing market. The point is to give banks money to make good investments/loans. I don't see how this resolves anything in the short term. At this point doing something to help struggling home owners is a completely seperate issue from what Paulson is trying to fix.
Posted by: DRB at Sep 24, 2008 3:20:56 PM
I wonder what he means by "efficient"?
I agree in part with DRB: Paulson is focused on bank's liquidity. The above proposal does address this by in essence guaranteeing every mortgage in the U.S. A true bailout: the banks lose nothing and homeowners lose their equity, but have their rent subsidized.
Also, see the Takings Clause.
Posted by: Norman Pfyster at Sep 24, 2008 3:42:15 PM
This plan won't be considered, becuase it does not satisfy the objective of granting huge new powers to a unrestricted federal government. It also does not have the side benefit of flowing hundreds of billions to the very well connected financial elites in control of Goldman Sachs and JP Morgan. Sorry, that is reality.
Posted by: Gabe at Sep 24, 2008 3:47:43 PM
Isn't this the Baker/Samwick proposal?
Posted by: no at Sep 24, 2008 3:51:17 PM
I agree with y81 on the analysis on this plan, it's over simplified. Occam's Razor does not apply here.
Also (and much more importantly), when is Tyrone going to offer up his thoughts on the financial crisis?
Posted by: Andy M at Sep 24, 2008 3:51:18 PM
This just doesn't seem right.
It can't really be that the problem is the securities aren't worth anything. I don't know nuffin', but mustn't it be that the sale effectively books the losses?
I've seen no discussion of eliminating the mark-to-market rule. Of course, I only read MR.
Posted by: Andrew at Sep 24, 2008 3:52:02 PM
The bailout is not about the socialist plea to "help the poor". That is merely the rationale they use to convince naive Rawlsian economist into creating intellectual arguments in favor of intervention. Once the naive economist have made enough bs justifications for intervention then the powerful take over and create legislation to rob the poor and the middle class.
Good job guys with that pragmatic marginal revolution.
Posted by: Gabe at Sep 24, 2008 3:52:14 PM
Let the private sector do it. Stimulate private actors to buy these distressed properties and turn them into rentals by temporarily eliminating or dramatically reducing federal income taxes on residential rental incomes for a period of time (3-5 yrs?).
Posted by: BAM at Sep 24, 2008 3:56:16 PM
I'd prefer that we lower the mortgage payments, say to 85% or so, so that the banks can have a nice haircut.
Posted by: John at Sep 24, 2008 3:58:02 PM
So the government takes the loss on the depreciated value of the home, rents the home to the (previous) owner at market rates, and pays off the banker who made the original loan. Tell me:
1) Why this is incentive compatible: You are bailing out the homeowner (who now gets to live in his too-expensive house for a lower monthly payment) and you are bailing out the mortgage originator (who gets a risk-free monthly mortgage payment for making an extremely risky loan)?
2) Why this plan differs from a plan where the government buys the mortgage from the banker, writes down the loss from the depreciated home, and refinances the mortgage to the owner at current market rates. I've heard of this plan already and it's called the Paulson plan.
Posted by: Adam at Sep 24, 2008 4:01:32 PM
re: takings clause. Doesn't it seem likely that homeowners would accept the deal? The rent the government would charge is presumably less than the mortgage they were paying.
But what happens to homeowners' debt? Suppose you borrowed $400K to buy a home that's now worth $300K. You fell behind; now the government owns your house and is making your mortgage payments for you. You rent your house from the government; but, meanwhile, do you still owe the bank, and if so, how much? $400K? $400K - the market value of the home, whatever that is? If you now owe nothing, the offer will be appealing to a lot of homeowners who are perfectly able to pay their debts.
One thing to note: If a lot of homeowners are turned into renters, they lose the incentive to maintain and improve the places they live in. Result: some of the value in the housing stock is destroyed. That achieves the end of Cowen's "modest proposal."
My sense is that homeowners should still end up owing something, not to the banks, but to the government. The government has superior ability to force them to pay. There should probably be some forebearance at some point. Hmm...
Posted by: Nathan Smith at Sep 24, 2008 4:02:56 PM
I had similar thoughts, as well. It seems as though the level of intervention to stave off further deterioration in the credit markets is imprecise and misplaced. Since the mortgages within the toxic CDOs cannot be properly evaluated to determine the ex ante risk and prevalence of default (and consequently their worth), why not focus the intervention on the individual mortgages within these instruments? The entire proposed bailout seems to suffer from an ecological fallacy, no?
Posted by: Marshall at Sep 24, 2008 4:05:36 PM
First of all, the gov't owns the house so it has the option of putting it up for rent, which presumably it would do in the short run. The proposal is not to require this. It might make sense to give preferential treatment to the current resident, but again there is no reason to require this.
It is incentive-compatible because no new option is given to the homeowner that wasnt already there. The homeowner loses the house and has the option to rent a house at market rates. They had that option before: foreclosure.
Posted by: Jeff Ely at Sep 24, 2008 4:11:06 PM
What about opening up Colorado, Utah, Wyoming, offshore and elsewhere to mineral and energy extraction, in addition to selling some federal land? Sell anything that has value: spectrum, pollution credits, etc. Let home prices and mortgages fall where they may, and use the sales revenue as a credit backstop.
Or, buy the mortgages and attach mineral rights as a sweetner. Buy an Alt-A death pool and we'll throw in a free coal mine in Utah. But wait, there's more! If you call in the next 30 minutes...
Posted by: 8 at Sep 24, 2008 4:11:33 PM
One of my business partners and I are looking to start buying out in default mortgages at discounts and rent or selling the homes back to the homeowner. If we seel we will hold the mortgage.
Posted by: floccina at Sep 24, 2008 4:11:46 PM
There must be some way for people with cash to profit from all this. All ideas apreciated.
Posted by: floccina at Sep 24, 2008 4:14:17 PM
Also, what's important to keep in mind here is that any policy intervention under consideration has distributive consequences and, as such, is vulnerable to rent-seeking. Financial firms have profound mobilization advantages over more diffuse, less concentrated, interests, such as homeowners. Which, despite its appeal, draws into question the tenability of Ely's plan.
Posted by: Marshall at Sep 24, 2008 4:24:09 PM
Ideas like this have been circulating in Britain for some time. The problem in implementing them is the clumsiness of central government.
However a programm of modest susides for the sort of enterprise floccina has in mind might do the trick cheaply and effectively.
In passing, has anyone any where suggested a plan which looks less efficient than Paulson's?
Posted by: Diversity at Sep 24, 2008 4:25:35 PM
Jeff,
You wrote, "It is incentive-compatible because no new option is given to the homeowner that wasnt already there. The homeowner loses the house and has the option to rent a house at market rates. They had that option before: foreclosure."
Then why do it? As you say, they already have that option.
David
Posted by: David R. Henderson at Sep 24, 2008 4:26:58 PM
OK, you asked for thoughts. I apologize in advance.
What are the market failures and what is the potential role of government?
1) The contracts underlying the CDOs and MBS were inflexibly constructed and failed to foresee forclosures that arise because of falling home prices. This has created a classic public goods problem. The diffuse ownership of cash flows from the underlying mortgages, the complexity of the securities, holdout problems, etc. mean that efficient renegotiations and modifications of mortgages cannot occur.
In the old model, forclosures were the result of idiosyncratic income risk for homeowners--the guy couldn't pay his mortgage so you took the property and sold it at market prices and received the value of the home as collateral, minus a LARGE transaction cost (something like 20-40 percent or even larger). It's premised on the idea that the person in the home would not be the highest bidder on the property. Maximizing profit usually implied foreclosure.
In the current crisis, mortgage delinquency is the result of people having negative equity in their homes because of falling prices and choosing to walk away. In this case, the person in the home probably is the high bidder on the property--but at the lower market price. In this world, you would save the transaction costs and strike a better bargin by renegotiating the mortgage with the homeowner. You'd make the homeowner better off and the mortgage creditor better off.
The public goods problem is that the structure of the CDOs and MBS prohibit these efficient transactions. These mortgages are held in pools, the cash flows are directed to MBS, which are in turn, repackaged into CDOs. No one has direct ownership so no one can direct the mortgage servicer to renegotiate the mortgage. When there are multiple mortgages on a property, renegotiating one mortgage benefits the other mortgage holders, so no one is willing to go first.
Potential solutions to this failure:
1) Buying second lien mortgages with the $700 billion and just writing them off: These are worth virtually nothing right now anyway, and by getting rid of second liens you would make it more attractive to first mortgage holders to renegotiate those mortgages--reducing forclosures and "unlocking" value.
2) Buying entire chains of MBS and CDOs. If you owned every claim on every mortgage in a pool of mortgages, you could unwind the CDOs and MBS, eliminate the conflicts due to multiple ownership, and renegotiate the mortgages.
3) Reform bankruptcy: Allow judges to re-write terms in these mortgages, effectively writing down the principle to appraised value or ability to pay (or whatever the judge arbitrarily wants). This solves the renegotiation problem by disolving the contracts, but I'm not sure that Judge Judy’s court is the right place for these things to be worked out.
4) The government disolves the contracts another way outside of bankrupty, like having a housing authority do the work, or authorizing mortgage servicers to renegotiate mortgages held in MBS or CDOs. Basically the model is the same for delinquent credit card debt—you force the unwinding of the CDOs and MBS and then auction off the individual debt to the private sector. Let the private creditor and the homeowner strike a bargain and avoid forclosure when it’s efficient to do so.
Bigger problems:
2) Lack of liquidity in the mortgage security market (the Administration’s view of what the failure is). Everyone is trying to dump their securities at the exact same time, pushing down prices due to liquidity rather than because the value of these assets is fundamentally low. It's like in the development literature when everyone wants to sell their ox when the harvest fails--you can dump assets when hit with an idiosyncratic shock, but not when it's a correlated and undiversifiable risk. If you think the government has a role mitigating undiversifiable risk for which no private market can address, then you’d think the government should come in and soak up that risk.
Currently, this problem is compounded by accounting and regulatory rules that force companies to mark their assets to market--everyone's dumping assets at firesale prices, everyone else then has to mark their assets to those firesale prices, this makes everyone's balance sheet look terrible, so everyone has to dump more assets at even lower prices..... Or, as I think has been happening at a lot of banks like Lehman, they have been refusing to mark to market and have been pricing their assets at what they believe is fair value, which has made them fodder for the shorts who can correctly claim that they are valuing their assets much higher than everyone else.
[I am skeptical of this view because there is a lot of money floating around in hedgefunds, private equity, soverign wealth funds, distressed debt funds. I think the truth is that these assets really are just not worth very much.]
One solution is to take the $700B and make a market for these securities; try to value these in a NPV sense and pay that price--above the liquidy-reduced price one can get in a firesale, but below a price that would force taxpayers to take a loss. Basically soak up the undiversifiable liquidity risk premium.
Of course, if these things are actually trading at NPV then the government's plan doesn't do anything--balance sheets are still too thin to go about business normally--unless the government over pays for the assets. If we start paying too much, then we're just re-capitalizing the banks by giving the banks with the worst assets, the most egregious business practices the most money. Not good incentives.
3) Network externalities when banks have thin capital reserves. All banks have been hit, to a lesser or greater degree, with a big negative shock to their assets which has pushed all of them close to insolvency because of how leveraged they are. Furthermore, banks are so connected these days--they are counterparties to each others transactions, hold each others bonds and stocks, and are more generally on the hook for each others losses. If one goes, others will go, as we saw with Lehman effectively taking AIG down (AIG "insured" Lehman's debt through credit default swaps).
The private market is able to deal well with idiosyncratic risk—the risk of one firm going under—because they can diversify and insure, but isn’t good at deal with multiple, correlated risks created by the fact that banks are so interdependent. Judging by OIS or TED spreads, the risks of multiple failures seems really high (they obviously cannot diversify the risk of banks failing overnight). I think this network externality and more generally, this undiversified risk of interbank lending is the key problem. No one wants to lend to anyone else.
The solution here is just to recapitalize financial intermediaries. If we did, as Elmendorf suggests, buy up X% of many banks for cold cash, most banks would no longer be at risk of failure, and more importantly, banks would know that their counterparties would no longer be at risk of failure. You'd get rid of the network failures, you'd reduce the undiversifable risk of interbank lending, and you'd get banks lending again. A further benefit, is that you wouldn't reward the bad banks anymore than the good banks--you'd have a flat X% of the entire sector and the bank that made really stupid moves, they'd get X% - their stupid losses; Goldman would get X% + their gains. We reward winners and the incentives are better.
I also think this has a better long run return for the taxpayer--whereas I don't have good sense that we would get a good price on individual mortgage securities, I do think we'd have a better chance of getting our money back if we just bought 10% of the financial sector at current prices. Wall Street will make money in the future. And hey, we already “own” 30% of the financial sector because of the corporate income tax, dividend tax, and capital gains tax, so why not a little more?
Posted by: adam at Sep 24, 2008 4:29:58 PM
What does Tyrone Cowen think?
Posted by: odograph at Sep 24, 2008 4:45:11 PM
The assets are worth whatever you can sell the underlying houses for in a nation-wide fire sale to buyers with good credit. The problem is that foreclosure and resale takes time and people and nobody wants to buy that headache. There are lots of deserving renters with good credit histories who sat out the bubble and would buy a home at the right price.
Posted by: jim at Sep 24, 2008 4:53:50 PM
