Government and Markets: a Call for Sensible Solutions to the Financial Crisis

March 2009. The latest news is another historic rise in the unemployment level and more troubles with major banks and corporations… What to do? I believe that government and markets can work hand in hand to help solve this crisis. Below are three ideas in that direction.

How to Help Homeowners, Mortgage Banks and Restart the Housing Market
Many honest people got into houses that they could not afford based on bad mortgage counseling. But speculators used interest-only or adjustable rate mortgages, with the idea of reselling these houses quickly. These people gambled and lost. They should not get a clean bill of health. This undermines the trust in the rescue package, and the willingness of banks to lend again. The Treasury’s new plan “The Home Affordable Refinance Program” to essentially renegotiate these loans is only partially viable.

Proposal #1: I propose to introduce a new type of mortgage into the marketplace: the Upside Shared Equity Mortgage (USEM). These mortgages would be renegotiated at lower interest rate based on the initial mortgage principal. However, a bank would add a clause in these new contracts that it (the bank) is entitled to getting a set percentage of the capital gains when the family sells the house or transfers the property to another owner. Bequests would be treated the same way. To avoid manipulations, the bank would for example specify that the bank’s cut cannot be smaller than say 20% of the capital gains computed based on the most current tax assessment of the property. If the tax assessment is too stale, banks could mandate that three market value assessments be made by independent assessors. Banks can certainly model the risk associated with capital gains and how this translates into a reduction of the mortgage interest rate. They may take some losses but not as much as under the current Treasury plan, and speculators would be more penalized.

How to Halt the Domino Effect of Toxic Assets Bringing Down the Real Economy
Credit Default Swaps are over-the-counter unregulated insurance contracts. In September 2008, about $60 trillion worth of Credit Default Swaps contracts constituted “contingent” debt for the financial sector which recorded these transactions off-balance sheet! This debt is triggered when third parties default on their debt, mainly mortgage pools. Around that time, the total liabilities shown in the aggregated balance sheet of the financial sector was roughly $25 trillion (including commercial banking, property and casualty and life insurances companies, and excluding pension funds, mutual funds etc..). If one estimates at $30 trillion the effective liabilities resulting from CDSs, by excluding companies on both sides of the market and contracts that expired or got unwound, this means that these credit default swaps were effectively doubling the size of the financial sector liabilities, under the worst case scenario.
It is now recognized that AIG’s downfall was precipitated by them offering up to $450 billion worth of CDSs contracts. When the risk of the underlying debt rose up, it led to a downgrade of AIG and calls for more collateral they did not have. Most of the outstanding CDSs contracts in our economy are “Naked” CDSs; that is transactions in which none of the parties have a direct stake in the underlying insured debt. In other words, these are side-bets on the health of a third party.

Proposal #2: 1) NO money provided by the tax payers for bailing out institutions should be allocated to pay for side-bets “naked” CDSs. More importantly, 2) the Fed and Treasury should work in concert with the financial industry and declare a one-time moratorium on all “naked” CDSs side-bets. The point is that these side-bets can bring the real economy down to its knees by spreading bankruptcies to the real sector, and they should not be allowed to do that. While some hedge funds will cry foul, all these side-bets are based on gambling money. Financial institutions should write-off these side-bets CDSs and bank regulators should allow for temporary modifications regarding the conditions that lead to declaring financial institutions’ insolvency based on the revised equity and assets and capital reserve ratios. Institutions heavily involved (90% or more of the value of assets in CDSs prior to the crisis) in these side-bets should be allowed to fail and should not be rescued by the government.

Another “Philadelphia Experiment”: Gathering the Best Minds in the Country
From May to September 1787 a group of fifty-five of the brightest collection of minds of that time gathered and confined themselves to a meeting room in Philadelphia to hammer out what has become one of the highest and noblest declarations of human potential: the American Constitution. This is such time of emergency and great potential.

Proposal #3: The Federal Government in concert with financial institutions should immediately convene a 4-weeks long convention of the 100 brightest academic and business minds in the country who are experts in Financial Economics, to put their mind at work for solving this crisis. At the end of four weeks, taskforces would report on the best solutions they can come-up with. These solutions would be proposed with the utmost scientific objectivity and with full disclosure of any ideological and political bias. The reports should be presented to congress and legislation should be drafted in the following month to adjust and rectify ongoing policies as seen fit.