Time to Recapitalize Households

In the last few weeks we have seen dramatic shifts in the position of governments on the current financial crisis. In the UK, Gordon Brown has spearheaded direct government equity stakes in banks, and is pushing for long-run structural fixes.[1] Following similar moves elsewhere in Europe, the Bush administration has jumped on board as well. Markets have now factored in expected government support, in the form of debt forgiveness (i.e. tax payer bailouts) and equity injections. As such, we should not expect dramatic changes in market performance at the moment unless new information emerges.

As this drama unfolds, here has been a parallel debate in the context of the U.S. Presidential elections on what to do with bad mortgages. The McCain plan was a version of the Bush plan -- have taxpayers take over bad loans. This has been heavily criticized. Yet, they are correct that something needs to be done in the housing market. In the old days, with the FSLIC, if a Savings and Loan failed, the government would have been the one to ultimately step in and clear housing stocks. This did not end well last time, and it is not clear why the current analogue will be any better. Already we are seeing discussion of what to do about increasing foreclosure rates.[2]

Here is a crazy idea, instead of just buying up bad mortgages at face value -- Recapitalize Households. What I mean is the following.

1. in cases where households now owe more than their house is worth, but where they can make payments on a mortgage at the current value (i.e. a proper credit check), the government buys the mortgage from the current holder at the current value of the property -- NOT at the face value of the mortgage


2. The government takes an equity stake (up to perhaps 25%) in the property itself, shared with the homeowner and to be recovered at sale of the house.


3. Details can be worked out, but a logical set-up is that the government shares any future increase in property value with the homeowner. This provides an incentive to the homeowner to care for the value of the house, while providing relief from the drop in values. It also imposes part of the cost and responsibility on the owner.


4. The government uses its greater market power to borrow, and finances a new mortgage for actual equity at a better rate -- improving the cash-flow position of the household.


5. A provision is included to allow homeowners to trade more equity to the government, up to some limit, in exchange for cash now.
   
   

Such a program would have the following effects:

• banks would receive some relief as we reduce pressure from bad mortgages and they recover market value without all the risks of dumping a large stock of vacant housing


• homeowners can stay in their homes


• the government recapitalizes households (relieving cash-flow and solvency problems)


• households and banks both carry the costs of the bad loans


• government will recover costs as the housing market recovers

Given the stricter redrafting of bankruptcy laws in the U.S., something of the sort will be necessary to prevent a political firestorm if housing markets get much worse.

References

[1] "Gordon Brown's call for a new Bretton Woods gains traction ," 15 October 2008, The Telegraph.
http://www.telegraph.co.uk/finance/3201885/Gordon-Browns-call-for-a-new-Bretton-Woods-gains-traction.html

[2] Matthew Benjamin, McCain, Obama Promoting Populist Appeals on Rescue (Update2)," 14 October Bloomberg. http://www.bloomberg.com/apps/news?pid=20601070&sid=ahfMrINj__Mw&refer=home