When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 2 of 3)

Since the last debate Senator McCain cannot stop talking about renegotiating mortgages. I am partial to a plan that is in the likeness of the Home Owners Loan Corporation (HOLC), although I should make it clear this is not the Senator’s idea. Thanks belong to FDR (or one of his brilliant advisors) and Chairman Bernanke who happens to be a great depression scholar. Bernanke and Secretary Paulson reintroduced America to this concept over the summer, way before McCain claimed it for his own in the last debate at the end of October. The details of any government backed plan have not been released but this article will take a look at how a potential program could help the current crisis.

Part 2 - Home Owners Loan Corporation

A program like the HOLC has two core principals: (1) A government lasts forever, which means they can wait forever for a return on investment; (2) A government has easy and inexpensive access to capital by way of issuing treasury bonds. Putting these two principles together the HOLC worked by issuing long term cheap government debt, and then used this capital to buy out troubled mortgages, taking the place of a private bank. The terms of the restructured mortgages were also extended (allowable by principle 1) spreading out the mortgage amount over more payments, which reduced the monthly payments substantially. [1]

Access to inexpensive capital will help the general liquidity crisis the banks are experiencing and allow homeowners access to a fixed rate. One can easily imagine a government backed program that can offer even the riskiest lender somewhere around a prime rate because the cost to obtain capital is so low. Today’s 10 year treasury sits just below 4%, add approximately 3 points for administration costs (I think this may be underestimating for a government run program of this size) and you have just about today’s Wall Street Prime. With this in place we can get homeowners out of their high adjustable rates and down to a reasonable 7%.

To address the problem of the overleveraged troubled borrower outlined in my previous installment, the term of each loan must be a cornerstone of the program, which may be politically sensitive. The 1930s HOLC program extended terms from the common 10 years to one more typical of today’s market, 25-30 years. As a core principle of this program the restructured mortgages must increase the term of the loan to reduce monthly payments. By extending the term the inflated principle can be spread out over a longer period, reducing monthly payments to an affordable level, keeping borrowers in their homes, and allowing the real estate market to turn around. I can only assume today’s 30 year mortgages would need to be extended to a minimum of 50 years, possibly longer depending on an applicants mortgage amount. The increased term makes these inflated prices affordable on a monthly basis avoiding foreclosures. I anticipate political sensitivity because a 50 year mortgage is a very new concept to most Americans (not all, it has had a limited introduction in very expensive markets, New York and California). It brings with it the reality that mortgages may be passed down through generations and a new time horizon for owning a home that many Americans may not be comfortable with. I think this John McCain is not telling Americans about this important concept because he cannot sell it in a 40 second news clip.

A new HOLC is a good idea but we all have to recognize it will take time and have some upfront government costs. The administrative cost can (ands should) be tied up into the issuance of each loan but this is a massive government undertaking and should not be taken lightly. As of September 4 million American Homeowners, many more may be making payments but barely staying above water. These troubled mortgages will need to be reassessed through this program. The loans will have to be underwritten again, and a reasonable long term debt service established. Individual attention will need to be given to each applicant which prevents a cost saving pre-packaged design. Since a general form cannot be created, loan officers with a fairly high skill level will be needed to run this process (lucky enough there are a lot of bankers looking for work right now). Dare I suggest Freddy and Fannie could do the work because they may have the infrastructure. If this were to occur they would have to act as government agents, restricted from profiting from the new loans while the government takes on all the risk otherwise we will create another bubble (see “Truly understanding the credit crisis and why it isn’t all Greenspan’s fault). The ideal would be an organization that acts solely in interest of the government, (is the government) and with the goal of structuring loans that protect taxpayer capital. Government once again becomes our bank. Sound expensive and complicated? – It will be, but at least it might work.

[1] I have just recently started educating myself on the details of the HOLC process. I do not claim to be a great depression scholar but this site was great for a pointed description and the Washington Post had a great article back in the spring.


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