[Not endorsing, but posting because it seems interesting, esp. the first part, which seems easily incorporable into other plans]
http://faculty.chicagogsb.edu/luigi.zingales/research/PSpapers/plan_b.pdf
Plan B
<snip>
We need a different solution: a Plan B. A plan that minimizes the money
the Government uses in bailing out Wall Street and Main Street to save
our precious dollars for a stimulus package, which will be essential to
restarting the economy.
Rescuing Main Street
Suppose that you bought a house in California in 2006. You paid
$400,000 with only 5% down. Unfortunately, during the last two years
the value of your house dropped by 30%; thus, you now find yourself
with a mortgage worth $380,000 and a house worth $280,000. Even if you
can afford your monthly payment (and you probably cannot), why should
you struggle to pay the mortgage when walking away will save you
$100,000, more than most people can save in a lifetime? However, when
the homeowner walks away, the mortgage holder does not recover
$280,000. The foreclosure process takes some time during which the
house is not properly maintained and further deteriorates in value. The
recovery rate in standard mortgage foreclosures (which will not take
place in the middle of the worst crisis since the Great Depression) is
50 cents per dollar of the mortgage. I am generous in estimating that
under the current conditions it might recover 50 cents per dollar of
the appraised value of the house; right now, it is only 37 cents per
dollar of the mortgage, which given a house appraised at $280,000
equals only $140,000 for the mortgage holder. In other words,
foreclosing is costly for both the borrower and the lender. The
mortgage holder gains only half of what is lost by the homeowners, due
to what we economists call underinvestment: the failure to maintain the
house.
In the old days, when the mortgage was granted by your local bank,
there was a simple solution to this tremendous inefficiency. The bank
forgave part of your mortgage; let's say 30%. This creates a small
positive equity value--an incentive--for you to stay. Since you stay
and maintain the house, the bank gets its $266,000 dollars of the new
debt back, which trumps the $140,000 that it was getting through
foreclosure.
Unfortunately, this win-win solution is not possible today. Your
mortgage has been sold and repackaged in an asset-backed security pool
and sold in tranches with different priorities. There is disagreement
on who has the right to renegotiate and renegotiation might require the
agreement of at least 60% of the debt holders, who are spread
throughout the globe. This is not going to happen. Furthermore, unlike
your local bank, distant debt holders cannot tell whether you are a
good borrower who has been unlucky or somebody just trying to take
advantage of the lender. In doubt, they do not want to cut the debt for
fear that even the homeowners who can easily afford their mortgage will
ask for debt forgiveness.
Here is where government intervention can help. Instead of pouring
money to either side, the government should provide a standardized way
to re-negtiate; one that is both fast and fair. Here is my proposal.
Congress should pass a law that makes a re-contracting option available
to all homeowners living in a zip code where house prices dropped by
more than 20% since the time they bought their property. Why? Because
there is no reason to give a break to inhabitants of Charlotte, North
Carolina, where house prices have risen 4% in the last two years.
How do we implement this? Thanks to two brilliant economists, Chip Case
and Robert Shiller, we have reliable measures of house price changes at
the zip code level. Thus, by using this real estate index, the
re-contracting option will reduce the face value of the mortgage (and
the corresponding interest payments) by the same percentage by which
house prices have declined since the homeowner bought (or refinanced)
his property. Exactly like in my hypothetical example above.
In exchange, however, the mortgage holder will receive some of the
equity value of the house at the time it is sold. Until then, the
homeowners will behave as if they own 100% of it. It is only at the
time of sale that 50% of the difference between the selling price and
the new value of the mortgage will be paid back to the mortgage holder.
It seems a strange contract, but Stanford University successfully
implemented a similar arrangement for its faculty: the university
financed part of the house purchase in exchange for a fraction of the
appreciation value at the time of exit.
The reason for this sharing of the benefits is twofold. On the one
hand, it makes the renegotiation less appealing to the homeowners,
making it unattractive to those not in need of it. For example,
homeowners with a very large equity in their house (who do not need any
restructuring because they are not at risk of default) will find it
very costly to use this option because they will have to give up 50% of
the value of their equity. Second, it reduces the cost of renegotiation
for the lending institutions, which minimizes the problems in the
financial system.
Since the option to renegotiate offered by the American Housing Rescue
& Foreclosure Prevention Act does not seem to have been stimulus
enough, this recontracting will be forced on lenders, but it will be
given as an option to homeowners, who will have to announce their
intention in a relatively brief period of time.
The great benefit of this program is that provides relief to distressed
homeowners at no cost to the Federal government and at the minimum
possible cost for the mortgage holders. The other great benefit is that
it will stop defaults on mortgages, eliminating the flood of houses on
the market and thus reducing the downside pressure on real estate
prices. By stabilizing the real estate market, this plan can help
prevent further deterioration of financial institutions' balance
sheets. But it will not resolve the problem of severe
undercapitalization that these institutions are currently facing. For
this we need the second part of the plan.
Rescuing Wall Street
The plan for Wall Street follows the same main idea: facilitating an
efficient renegotiation. The key difference between the Main Street and
Wall Street plans is in the ease of assessing the current value of the
troubled assets. It is relatively easy to estimate the current value of
a house by looking at the purchase price and at the intervening drop in
value (per the Case and Shiller index). In banks, however, the lack of
transparency makes this estimation very difficult. To avoid having to
come up with this estimate, which would be a difficult process and one
fraught with potential conflict of interests, we are going to use a
clever mechanism invented twenty years ago by a lawyer economist,
Lucian Bebchuk.
The core idea is to have Congress pass a law that sets up a new form of
prepackaged bankruptcy that would allow banks to restructure their debt
and restart lending. Prepackaged means that all the terms are
pre-specified and banks could come out of it overnight. All that would
be required is a signature from a federal judge. In the private sector
the terms are generally agreed among the parties involved, the
innovation here would be to have all the terms pre-set by the
government, thereby speeding up the process. Firms who enter into this
special bankruptcy would have their old equity holders wiped out and
their existing debt (commercial paper and bonds) transformed into
equity. This would immediately make banks solid, by providing a large
equity buffer. As it stands now, banks have lost so much in junk
mortgages that the value of their equity has tumbled nearly to zero. In
other words, they are close to being insolvent. By transforming all
banks' debt into equity this special Chapter 11 would make banks
solvent and ready to lend again to their customers.
Certainly, some current shareholders might disagree that their bank is
insolvent and would feel expropriated by a proceeding that wipes them
out. This is where the Bebchuk mechanism comes in handy. After the
filing of the special bankruptcy, we give these shareholders one week
to buy out the old debtholders by paying them the face value of the
debt. Each shareholder can decide individually. If he thinks that the
company is solvent, he pays his share of debt and regains his share of
equity. Otherwise, he lets it go.
My plan would exempt individual depositors, which are federally
ensured. I would also exempt credit default swaps and repo contracts to
avoid potential ripple effect through the system (what happened by not
directing Lehman Brothers through a similar procedure). It would
suffice to write in this special bankruptcy code that banks who enter
it would not be considered in default as far as their contracts are
concerned.
How would the government induce insolvent banks (and only those) to
voluntarily initiate these special bankruptcy proceedings? One way is
to harness the power of short-term debt. By involving the short-term
debt in the restructuring, this special bankruptcy will engender fear
in short-term creditors. If they think the institution might be
insolvent, they will pull their money out as soon as they can for fear
of being involved in this restructuring. In so doing, they will
generate a liquidity crisis that will force these institutions into
this special bankruptcy.
An alternative mechanism is to have the Fed limit access to liquidity.
Both banks and investment banks currently can go to the Federal
Reserve's discount window, meaning that they can, by posting
collateral, receive cash at a reasonable rate of interest. Under my
plan, for the next two years only banks that underwent this special
form of bankruptcy would get access to the discount window. In this
way, solid financial institutions that do not need liquidity are not
forced to undergo through this restructuring, while insolvent ones
would rush into it to avoid a government takeover.
Another problem could be that the institutions owning the debt, which
will end up owning the equity after the restructuring, might be
restricted by regulation or contract to holding equity. To prevent a
dumping of shares that would have a negative effect on market prices,
it is enough to include a norm that allows these institutions two years
to comply with the norm. This was the standard practice in the old days
when banks, who could not own equity, were forced to take some in a
restructuring.
The beauty of this approach is threefold. First, it recapitalizes the
banking sector at no cost to taxpayers. Second, it keeps the government
out of the difficult business of establishing the price of distressed
assets. If debt is converted into equity, its total value would not
change, only the legal nature of the claim would. Third, this plan
removes the possibility of the government playing God, deciding which
banks are allowed to live and which should die; the market will make
those decisions.
Tomorrow is too late
The United States (and possibly the world) is facing the biggest
financial crisis since the Great Depression. There is a strong quest
for the government to intervene to rescue us, but how? Thus far, the
Treasury seems to have been following the advice of Wall Street, which
consists in throwing public money at the problems. However, the cost is
quickly escalating. If we do not stop, we will leave an unbearable
burden of debt to our children.
Time has come for the Treasury secretary to listen to some economists.
By understanding the causes of the current crisis, we can help solve it
without relying on public money. Thus, I feel it is my duty as an
economist to provide an alternative: a market-based solution, which
does not waste public money and uses the force of the government only
to speed up the restructuring. It may not be perfect, but it is a
viable avenue that should be explored before acquiescing to the
perceived inevitability of Paulson's proposals.
Originally published at Luigi Zingales' webpage and reproduced here
with the author's permission.