We're in a crisis here and there's no time to waste. We're being told that if we don't bail out Wall Street by buying up their derivatives, we're all doomed.
What I'm wondering is: What would happen if we put our resources into the underlying mortgages rather than into the traders' exotic, highly leveraged, house-of-cards debt instruments?
Perhaps this would better as a comment, but I'm hoping that some of our economic and financial services folks can provide assistance to compensate for my lack of knowledge and concurrent lack of research time. My apologies for not providing research. I just have a fundamental question/brainstorm that I'd like some reaction to.
We're being asked to prop-up financial institutions which have gone crazy. These are the people who have separated primary assets like a home and its underlying mortgage from the credit instruments which are used as collateral for corporate financing. This has resulted in:
Loan originators not being lenders Back when I bought my first home 33 years ago, the bank or S&L that I got my mortgage from was where I sent my payments. They also had my escrow account for taxes and insurance (required since I "only" had 10 percent down on my original 30 year fixed loan.) The banker actually was concerned about whether I'd be able to make those payments and did a lot of due diligence verifying my employment, my salary and my other debt.
Later, my bank stopped doing that, so when I bought my second (and current) home 18 years ago, the bank was mostly concerned about what Freddie Mac's underwriting and audit requirements were. There apparently was some accountability, because there were standards that they followed in making the loans. Since then, I've refinanced several times (into 15 year fixed, each time), but scrutiny has seemed far less stringent. (Yes, my income and ability to pay is much higher as well - so that may be the reason.) However reports and ads I saw for new loans talked of "no documentation," "no down payment," "low initial rates" and other inducements that would clearly get people in over their heads with ARMs that they'd never have a prayer of repaying. However it didn't matter because the loan originator didn't need to worry about the homeowner paying him back - his only concern was that he could sell it one step up the food chain / pyramid.
Underlying mortgages are bundled and rebundled
Once the loan is sold to the first buyer, it (or some derivative) is bundled into packages with other (allegedly) similar loans to create something that "real traders" can work with. Through some dark magic, we eventually wind up with MBS, CDS and an alphabet of instruments which only traders can understand. Unfortunately, many traders don't understand them (IMNSHO), but hey, you can trade 'em.
Eventually it all rolls up to huge, highly leveraged instruments which no one can accurately value
Finally we wind up with large financial institutions buying and selling products which they can't put an accurate valuation on. Here's where it gets interesting to me. They buy and sell mortgage packages and create other "stuff" to sell. (Or they hold the new "stuff" and sell some "newer stuff" based on the alleged value of the "stuff.") This gets repeated and repeated until no one really knows what any of the "stuff" is worth. At that point, you can't sell any more "stuff" at any level of the food chain because people finally refuse to buy something that they can't put a value on. It sounds like a classic Ponzi scheme to me, bwtfdik? These are highly educated, highly compensated financial professionals, aren't they?
So then, the taxpayers are asked to guarantee the value of all of the layers of derivative stuff
So that's where we seem to be today. We're being asked to buy this leveraged "stuff" (establishing a value for it.) It will apparently be worth whatever Sec. Paulsen decides to pay for it, using our money. No one is sure how much stuff we need to buy or what it's going to cost, but we can certainly trust the current administration. After all, these guys are former investment bankers who understand this magic.
Forgive me if I'm not too enthusiastic.
What if, instead of guaranteeing the "stuff" we cut out the middlemen and just guaranteed the underlying mortages?
Several points here:
- If $1000 of mortgage money is leveraged to $10K or $30K and the leveraged debt is in jeopardy due to the instability of the initial $1000, isn't it cheaper to guarantee the base investment rather than the derivative?
- Wouldn't money spent keeping people in their homes or restructuring their debt (or allowing bankruptcy terms where they could pay off the original loan (with Government making up the difference) and then get a new (guaranteed?) mortgage on terms they could afford. If they couldn't afford it, we've still got an issue and taxpayers may be owning homes like during the S&L bailout. At least we put our money directly to homeowners rather than lenders.
- This would only apply if people would go through bankruptcy. This is stronger than what the financial institutions are being asked to do. They just get to dump their bad paper. Homeowners would suffer credit damage for their complicity in taking loans they could afford or for their misfortune in not being able to make payments for other reasons. There are consequences to that.
- Taxpayers are on the hook for the difference between the original mortgage and the new mortgage - or for the difference between the eventual sale price of the home and the original mortgage. That will likely be a great deal of money, but it's not 100 percent of ANY mortgage, just the sum of the deltas between original value and new value.
- We'd need a massive bankruptcy infrastructure for a while. Fortunately one of the products this country continues to produce is lawyers, so I think that COULD be manageable. I don't honestly know.
- I have now idea how much the government would have to pony up in such a plan. However, no one seems to have any idea what the current MOAB would eventually cost either.
- I also naively assume that if underlying mortgages were "good debt" anything based on them would inherit that goodness. That may not be a good assumption.
Thanks for your patience with my first diary. Again, my apologies for not providing more factual information. I just want to get some feedback on my hare-brained scheme to see if it's any worse than Paulsen's scheme.