Buying Back Public Confidence - What Will It Take?

By Jon Hainer

On the one hand, the Treasury Department’s so-called economic “Bailout” plan is on the wrong track. On the other hand, Shiela Bair, Chairman of the Federal Deposit Insurance Corporation (the FDIC that insurance bank deposits) is on the right track. Yes, it is the Main Street v. Wall Street argument that is raging right now, with an added consideration, the increase in public confidence that would attend to a focus on the needs of American taxpayers.
It is clear that, in general, the public does not understand the difference between commercial banks and so-called “investment banks” i.e. Wall Street brokerage houses. As a result, banks in general are getting a bad rap which erodes public confidence in our financial institutions. At the same time, giving financial giants billions of dollars without conditions is a big factor in the erosion of public confidence: billions in government funds used to acquire “failing banks” and create bigger monopolies with which community banks have to compete; the multi-billion dollar tax breaks provided to the financial giants acquiring failing institutions; few caps on multi-million dollar salaries and bonuses to executives of the corporate giants receiving bailout money. How about the story in the Wall Street Journal of the $7+ billion purchase by Citi of a toll road in Europe? Banks should get “capital injections” not only when withholding help from them would create havoc on Main Street – but also as a reward for direct assistance to homeowners. Further, there should be a mandate that “Bailout” money be used to ease the credit crunch by increasing the availability of credit.
The current economic crisis was driven by a growing number of foreclosures at the bottom of the economic structure and the primary solution should start there. Subprime borrowers (those with poor credit) got subprime loans - higher points, fees and interest to offset the added risk of making such loans. Consequently, subprime borrowers who could least afford a high-priced loan got the least affordable mortgages. Most home loans had been fixed-rate mortgages, but most subprime loans were “non-traditional,” something that unsophisticated subprime borrowers often failed to understand. Examples were adjustable rate mortgages (low interest to start, but periodically resetting to higher interest and higher monthly payments). Hybrid mortgages (starting with a fixed rate and switching to an ARM loan after a couple of years), loans with payments of “interest only” that later converted to payments of principal and interest, often doubling or tripling the monthly payments, etc. The resulting monthly payments were unaffordable and triggered defaults and foreclosures, which created a backlog of unsold homes that caused home values to plummet. The public in general is unaware that lenders who are basically unregulated by any governmental authority, state or federal, such as loan brokers and mortgage companies, were responsible for originating a large percentage of the subprime loans that were sold to banks and subsequently pooled and resold to Wall Street.
When a home is worth less than the principal amount owed on a promissory note representing the mortgage loan, discouraged homeowners often hand the bank the keys and walk away. In the foreclosure process, the borrowers lose their homes and, on average, the lender loses 40% of the outstanding balance owed on the note. The FDIC Chair, Sheila Bair leans toward restructuring all viable loans. One option to help homeowners currently struggling to stay in their homes and cut losses by banks, would be for:
¨ The bank (or other regulated lender) to reduce the balance owed by the homeowner to the current value of the residential property, but not more (for example) than 20%.
¨ Treasury to reimburse the lender for half of the reduction on the homeowner’s promissory note, and also to guarantee repayment of the note as reward for the lender’s portion of the reduction.
¨ Treasury to place a lien on the property in the amount of its reimbursement to the lender (paperwork to be handled by the lender.)
¨ Loan terms to be extended up to 40 years and interest to be fixed at 6-7% as required to keep monthly payments under 35% of the homeowner’s gross monthly income.
¨ Treasury’s lien to reimburse the federal government (and the taxpayers) upon the sale of the property.
Some side issues would have to be considered: The lender would have to provide proof of the reduction in the amount owed by a homeowner, and 50% would have to be reimbursed to the lender by an authorized government agency (possibly the IRS with a temporary extension of manpower – which would help unemployment). However, collection on the government’s lien should be relatively automatic and should not require much, if any, paperwork.
How such a program could apply to mortgages that were pooled as the underlying collateral for “mortgage-backed securities” is unclear. The fact that writing down the principal owed on a mortgage affects the interests of those who invested in mortgage-backed securities is something that must be resolved at the federal level, perhaps by the Justice Department. However, the government has never insured stocks, bonds and similar investments, and investors should readily recognize that a small loss is better than a big loss.