ComingTogether Plan

Reasons

For the financial crisis of 2007-2009, there is plenty of blame to go around. Generally, the United States economy is robust enough to deal with mistakes — yes, the people that make mistakes suffer, but normally there is not serious impact on the whole economy. In this case, the majority of the people in this country, as well as many others around the world, have experienced difficulties. The following contributed to the perfect storm that resulted in the Subprime Financial Crisis:

1. Government encouragement of subprime lending –  There are programs that require specific percentages of home loans to go to minorities, to go to those with below median income, to go to those with income less than 60% of the median income.¹
2. Government encouragement of borrowing in general –  The current tax system subsidizes a great deal of borrowing in our economy and there are a number of government programs that guarantee or even make loans.
3. Credit-based economy –  The excessive debt taken on in our society, rather than basing economic success on actual production, has been a worrisome aspect of the US economy for many years. Remember when the definition of affordable was that “you had enough money to buy the item,” rather than “you can borrow the money to buy the item.” There are even people who define wealth by how much they can spend, rather than how much they have. The biggest concern about credit in the current crisis is that leverage increases volatility. Example: If a company that has borrowed 90% of its assets loses an amount equal to 10% of its assets, the owners are left with no value, because all the assets would be required to repay the debt. For individual families, credit allows the future paychecks to be spent in advance, so there is no margin to handle increases in expenses.
4. Commodity price and interest rate shocks –  There will always be changes in prices in a free economy. However, sudden, large changes can cause shocks to reverberate through an economy, especially a highly leveraged one. The five-fold price increase on oil since 2002 and the five-fold increase in the Federal Funds rate (controlled by the Federal Reserve) since 2004 were more than the US economy could handle. (We agreed with the Federal Reserve that interest rates needed to rise during this period. However, our opinion was that the increase needed to be slower. Government officials seem to constantly underestimate the effects of their actions in magnitude and in the length of time required to see all the effects.)
5. Adjustable Rate Mortgages (ARMs) –  Adjustable interest rates have been used for years when getting a loan for a business, but both sides typically avoided them for consumer transactions, as they are too dangerous for those without financial sophistication, and without the means to handle significant increases in monthly payments. The problem is that early in the mortgage, the vast majority of each payment is typically interest – the portion directly affected by the interest rate, which can be volatile. Therefore, if the interest changes by 50%, the payment (principal and interest) will change by close to 50%. This may make it impossible for borrowers who were already on shaky ground (see item 1 above) to make their mortgage payments, resulting in the sale of the house (driving down housing prices) or foreclosure (driving down housing prices even further). Note: Many ARM mortgages contain caps that can only allow the interest rate to be raised by 2% at each adjustment, so if you have an ARM at 4%, the new interest rate cannot be greater than 6%. So even if the percent increase is capped, at low interest rates, a rate increase of the maximum amount allowed by the cap can still be a large percent of the prior rate.
6. “Mark-to-Market” rules –  Many of the “losses” reported on mortgage securities are due to accounting rules that require companies to report assets at the current market price, meaning that when interest rates went up in 2007, the value of mortgages (and other long-term debt) went down, creating a loss on the books even though there had not actually been any cash flow out and holding the debt to maturity would result in no loss at all, assuming the borrower paid back what was borrowed. This is particularly serious for companies that have to maintain certain levels of capital to remain in business, artificially accelerating the crisis. Even during this crisis, 94% of the mortgages are still being paid on time as of this writing.²
7. Increase in “moral hazard” in investment decision making –  “Moral hazard“ is a term from economics reflecting the fact that many people will act differently when they do not bear the full consequence of their decision making. In other words, there are people who do not make decisions as carefully when they are using other people’s money. An example from the mortgage situation is the rise of the “mortgage originators” – the companies that write mortgages and then sell them to someone else. The mortgage originator makes money on each mortgage when it is sold, not when it is paid back, so there is incentive to make mortgages even if there is evidence that they will not be repaid. (Note: federal policies have also had an influence in this area, creating, as one economics researcher said, “a time bomb that was set off as soon as property values began to decline.“)³
8. Off-books liabilities –  When an entity takes on liability that is not shown on its balance sheet, investors do not have the facts necessary to prudently evaluate potential investments in that entity. The biggest example of this type of deception is the US government, which reports the national debt (which is too large by itself), but does not include in those figures loan guarantees and unfunded liabilities (retirement benefits for employees, veterans benefits for those who have already served the country in the military, Medicare, and Social Security).

It was just reported that the unfunded liability for Medicare and Social Security is now fifteen digits — $101 trillion,⁴ which is about ten times the national debt. These are off the books.

One of the interesting examples in the recent crisis is the case of Fannie Mae and Freddie Mac. These were two government-sponsored corporations that technically did not have government guarantees of their borrowing, but many investors assumed that the federal government would never let these institutions fail. They were right. The federal government allocated $300 billion to insure that these entities did not fail, but never reported that obligation as part of its liabilities.

Solutions – long term

It is best to start considering solutions which remove the sources of the problems, so that short-term fixes are not having to battle ever-increasing problems. Some of these, although considered long-term, if they could be done quickly would have a great immediate effect, and improve the economy in the future to reduce the likelihood of a repeat of the recent events.

1. Implement the ComingTogether Plan – The flow of benefits to citizens will reduce the effect job losses have on consumer spending. The simplified tax structure eliminates most of the incentive in the tax code to borrow.
2. Eliminate government regulations that require mortgage lenders to consider anything other than the ability to repay, when making lending decisions. I find it particularly offensive when the regulations require a potential lender to consider race. I remember when a civil rights leader had a dream that people “will not be judged by the color of their skin but by the content of their character.”⁵ For a loan, what better measure of the content of a person’s character than his or her credit score?
3. Stop government sponsored / guaranteed lending – Start with Fannie Mae and Freddie Mac. These companies, which “stimulated the growth of the subpar mortgage market and substantially magnified the costs of its collapse”⁶ are not necessary or useful to the housing market (as evidenced by the time in 2005 when these entities were not making loans due to their own accounting crisis). Fannie Mae and Freddie Mac should make no new mortgages and try to recover as much as possible from those it now owns. The flat tax in the ComingTogether Plan eliminates some partial sponsorship of borrowing. The only businesses that should be able to deduct interest expense are those that are regulated as banks. (Note that many of the regulated banks are buying assets of failed business. They are the financial companies that are generally still solid.)
4. If adjustable rate mortgages are going to be used for general consumers, the normal terms should be modified to protect against an unacceptable increase in the payment. Consider limiting the payment increase amount (for principal and interest) within any year to 7.5%. Assuming no more than one rate adjustment per year, the procedure at the date of a rate adjustment would be to amortize the remaining balance over the remaining term using the new interest rate. If the resulting payment is more than 107.5% of the prior payment, the new payment would be limited to 107.5% of the prior payment. Otherwise, it would just be the payment from the amortization calculation as is the current procedure. This may result in negative amortization in some years, meaning that the interest charged is more than the payment (for principal and interest), so the difference is added to the principal. In rare cases, it may mean that the mortgage will last longer than the original term before it is fully repaid.
5. Because many people have their property taxes included in the mortgage payment, a change in the assessment of property taxes is recommended. A property tax increase at the same time as an interest rate increase leaves the borrower little time to adjust his financial plan. There are a number of other reasons (beyond the scope of this page) to recommend that the appraisal is to be determined as of the last transfer of ownership. For arms-length transactions, this would just be the price agreed to by the buyer and the seller. Otherwise, the current system of obtaining appraisals would continue to be used.
6. Change the accounting rules to value the mortgages that are still being paid on a timely basis at the remaining balance. This would result in the same amount of profit being recognized over the life of the mortgage, but there would not be a requirement to mark it down one year when that markdown is recouped over the life of the mortgage. Of course, when there is evidence that the borrower is not going to be able to pay (such as missed payments), the mortgage has truly lost value, and that loss should be reported. Realize that houses are most valuable to the residents who own the home, due to memories made there, the cost of moving, the transaction cost associated with selling, etc., so many will continue paying the mortgage even when they are “upside down” compared to the market value of the home. Furthermore, most Americans will honor their signature on the mortgage, so the loan will be paid according to the terms even when the value of the home has declined.
7. Off-books liability reform – While much was done to address this issue in response to the Enron situation, more can be done, especially in the financial reporting from federal (and other) governments.
8. Sell federal government resources to reduce federal debt – Repeated studies have shown that lumber companies manage forests better than the bureaucrats,⁷ so sell federal land appropriate for that purpose. There are many natural resources, especially oil, owned by the government. Allow drilling, even in environmentally sensitive places, now that the technology allows us to do so with such small footprints for the surface operations. Also, sell the companies purchased (AIG, Fannie Mae, Freddie Mac) as part of the response to the financial crisis as soon as the economy can afford it. Also, as the federal employment shrinks as a result of Solution 1 above, government office buildings should be sold.

Solutions – short term

1. Bailout law — While the federal bailout passed by Congress and signed into law October 3rd, 2008, injects no new money into the world economy on a net basis (the government will borrow money to purchase the loans), it trades federal debt (often foreign held) for less certain mortgages owed by individuals, increasing the quality of the debt in the marketplace and injecting cash into the lenders’ balance sheet, allowing them to do more lending. This may have some positive effect, but the authorized amount is small compared to the size of the mortgage market ($12 trillion outstanding). Will it be enough? Probably not by itself, so more actions will be needed. The most positive item included in the bill was a relaxation of the MTM (mark-to-market) rules. The tax law changes are also good in that they avoid tax increases at a fragile time. Yes, it was called a “tax cut,” but that is just Washington speak for extending the tax law as it applies this year (or applied last year), rather than actually lowering taxes compared to the last tax return.
2. Lenders and borrowers could agree to change the terms of the adjustable rate mortgages currently in place to cap the increase in payment as suggested for new ARMs in long-term solution number four above. This would clearly benefit the borrower, but would also benefit the lender, as both foreclosure and carrying non-performing loans have a negative impact on their financial statements.
3. The investors that buy mortgages should insist on more information about borrowers and / or guarantees from mortgage originators as to the quality of the mortgages in the packages they buy, to reduce the information asymmetry that leads to moral hazard problems.
4. Increase energy production – Note that long-term solution number eight would have an effect sooner than many believe. The sellers of oil will sell when they think they can maximize the benefit to themselves. When they think future prices will be high, they raise the current price. Why sell a commodity at $50 if you think you can get $100 in five years? Having more oil production in the US will lower the expected future price of oil, and therefore, lower the price required to get sellers to release more on the market.

Summary

Understanding the reasons why we find ourselves in this situation is the beginning step to repairing it – and preventing it. Patience and more realistic attitudes towards a credit economy will be helpful in taking the steps for long-term economic well-being. However, there are several steps we can take right now to give our citizens peace of mind, and hope for the future. As the ComingTogether Plan points out, our people are our true wealth.

Roberts, Russell. “How Government Stoked the Mania: Housing prices would never have risen so high without multiple Washington mistakes.” The Wall Street Journal. Oct 3, 2008 (Oct 6, 2008). online.wsj.com/article/SB122298982558700341.html

“Editorials: A Replay Of 1929? Don’t Count On It.” Investors Business Daily. Oct 3, 2008 (10/06/08). www.ibdeditorials.com/IBDArticles.aspx?id=307927474219610

Lott,Jr., John R. “Analysis: Reckless Mortgages Brought Financial Market to Its Knees.” Fox News. Sept 18, 2008 (10/15/08). www.foxnews.com/printer_friendly_story/0,3566,424945,00.html

Whalen, Mike. “Forget the Bailout: Whither Our Debt?” Commentary, Washington Times.  Oct 7, 2008 (10/08/08). washingtontimes.com/news/2008/oct/07/a-101-trillion-sleeping-giant/

King, Jr., Martin Luther. “I Have A Dream”. Speech at Lincoln Memorial, Washington DC: August 28, 1963.

Calomiris, Charles and Wallison, Peter J. “Opinion: Blame Fannie Mae and Congress  for the Credit Mess”. The Wall Street Journal. Sept. 23, 2008 (10/08/08).  wsj.com/article/SB122212948811465427.html

Cohan, Lani and Burnett, H. Sterling. Brief Analysis No. 631 “In Order to Extinguish Forest Fires, Don’t Let Logging Burn Out.” National Center for Policy Analysis. Sept 10, 2008 (10/05/08). www.ncpa.org/pub/ba/ba631/ba631.pdf

Photo Credit: Marques Stewart, licensed under CreativeCommons.org, (10/13/08) thru flickr.com.

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