08.30.11

A simple solution to the housing market problem

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 4:02 pm

Forced debt to equity conversions have been proposed as a solution to make insolvent banks solvent again.  The idea is that some portion of a bank’s outstanding debt is converted into equity in order to restore a positive net worth (assets – liabilities).  There’s no reason why this same approach could not be taken with private homeowners.

Let’s look at a simplified example:

Home purchaser takes out a $100k bank loan to buy a $100k house.
Assets = $100k, liabilities = $100k, net worth = $0.

House price drops to $80k.  Now:

Assets = $80k, liabilities = $100k, net worth = -$20.

Undertake the debt to equity conversion:

Loan reduced to house market value = $80k.
In exchange, bank gets $20k equity = ($20k/$80k) = 25% ownership stake in house.

The homeowner essentially gives up 25% of future increases in home value in order to not be underwater now.

At some point in the future, the house will be sold.  When that happens, one of the following scenarios will play out.

Scenario 1 – House sells for <$80k.  Bank gets fraction of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 2 – House sells for $80k.  Bank gets all of its $80k loan back.  Bank gets nothing on its equity.  Homeowner gets nothing.

Scenario 3 – House sells for >$80k.  Bank gets all of its $80k loan back.  Bank gets 25%*(Home price – $80k) on its equity.  Homeowner gets 75%*(Home price – $80k).

At a sale price of $160k, the bank recoups all of its initial loan ($80k modified loan + 25%*$80k = $100k).  The bank makes a net profit on any final sale price over $160k.

The homeowner will also receive an option to buy out the bank’s equity at any point in the future for 25% * (Market value – $80k) plus some pre-determined premium.

This program would be open to all homeowners, banks would have no say in the matter.  Obviously, homeowners who are not underwater would not have any reason to participate.

Is this solution perfect?  No.

Is it preferable to a taxpayer-funded mortgage forgiveness program whereby the government pays banks to forgive a portion of underwater loans?  Yes.

Is it preferable to doing nothing and having the debt overhang doom the economy to a decade or more of below-potential GDP and high unemployment?  Yes.

I’m well aware of the difficulties involved.  The loan writedowns would impair bank earnings for a period of time (though there would now be future upside).  The impact on mortgage services, MBS, CDOs, and the holders of MBS and CDOs would be messy.  There would be lawsuits.  Again, it must be measured against the alternatives and not some utopian fantasy world where all debts will be eventually paid in full and no losses have to be taken.

What I’ve laid out above is a simplified, stylistic version.  All sorts of modifications could be made to improve it.  The percentage of debt converted could be increased to provide additional monthly payment relief.  The equity structure could be modified to give the bank a bigger percentage claim on the first $20k in price appreciation.  Other terms of the loan could be modified.  The point here is just to lay out a set of guiding principles; the details can be hashed out later.

08.25.11

Barro on “Regular Economics vs Keynesian Economics”

Posted in Economics, General Musings at 8:47 am

Very odd statement:

http://uneasymoney.com/2011/08/24/barro-on-keynesian-economics-vs-regular-economics/

Barro’s “regular economics” describes a world that is always operating at 100% capacity with zero unemployed labor or idle capital.  Thus, resource and technology constraints mean that there is a real tradeoff between government spending and private spending and between current consumption and investment spending.

“Keynesian economics” describes a world that is not operating at capacity, and therefore has unemployed labor and idle capital.  In such a world, it is possible to increase government spending and private spending simultaneously, or to increase consumption and investment simultaneously.  In fact, doing so moves the operation of the economy closer to its capacity.

Which world best describes our current state of affairs?

08.09.11

Fed Announcement

Posted in Economics, Financial Markets, Politics and Policy at 7:25 pm

The Fed announced at 2:15 that it would hold the Federal Funds rate near zero for 2 years.

More significant was what it did NOT announce:

  • It did not announce it would keep rolling over its bond portfolio for 2 years.
  • It did not announce it would change the composition of its bond portfolio to longer maturity bonds.
  • It did not announce it would cut the interest rate (0.25%) it pays on bank reserves.
  • It certainly did not announce QE3.

The immediate market reaction was predictably negative – market consensus was for more action by the Fed.

However, that reaction was short-lived, and the market soon took off like a rocket.  Very odd.