10.01.2008 0

A Non-Bailout Solution: We Need a Traffic Cop!

  • On: 10/22/2008 15:23:46
  • In: Monetary Policy
  • Whenever there is a big car wreck on the highway, it is invariably necessary for a traffic cop to come in and direct traffic around the wreck. Once the traffic is flowing away from the scene, the busted-up cars can be cleared.

    The AP is reporting that Treasury Secretary Henry Paulson is considering the creation of Resolution Trust Corporation-style (RTC) solution to the current mortgage crisis. Ostensibly, the new corporation would take on all of the bad debt of the banks. At first blush, this may seem like yet another bailout, but it need not be.

    In fact, it could be a limited government solution, especially when compared to what has been done thus far. The fact is, by purchasing Fannie Mae and Freddie Mac, and now AIG, the government is taking on far more liability than it needs to in order to solve the actual problem, which are these bad debts. Secretary Paulson deserves credit for his efforts to move in this direction.

    Instead of bailing out entire companies or nationalizing them, going to the root cause of the problem is the most favorable outcome, and the speediest solution, if there needed to be a government solution.

    An RTC solution could work, but it would need some clear principles moving forward to minimize the taxpayer burden, and to prevent this catastrophe from happening again. Here’s what we would suggest:

    1) Creation of an RTC to assume all bad debts by all banks on a voluntary basis by private lenders. All bad debts in Fannie Mae, Freddie Mac, and any other government bank would be put into the RTC on a mandatory basis. The RTC assumes control of these mortgages. It attempts to work out terms If there is a foreclosure, the RTC owns the property. It can be sold. It could be burnt to ground.
    2) After the bad debts are moved, the mortgages and securities held by Fannie, Freddie, and elsewhere by the government would be sold to private banks and firms. Once the bad debts are removed from these entities, the risk posed by acquiring the rest of the good debts on favorable terms is completely minimized. This could happen over the course of 24-48 months.
    3) The loose lending practices and ACORN-inspired welfare programs need to be thrown into the trash where they belong. We don’t need loose credit in order for the glut on the housing market to clear. We need smart credit. Honest credit. This will allow home values to bottom out finally and simultaneously build consumer confidence, because the values of the homes will actually mean something when a loan is given. Put another way, if blood banks operated the way lenders were with subprime and Alt-A loans, the blood supply would be completely tainted and unsafe to use. There must be appropriate screening for borrowers, and then the housing market will know what the actual demand for homes is. There will not be any more glut on the housing market in the future.
    4) Banks would actually need to be disincentivized to a certain extent from dumping bad debt into this RTC so that they don’t wind up dumping too much debt on the government. So, when a bank dumps the bad debt, they get no bailout. Instead, the RTC gets the debts at a big discount, and the banks still take a loss. This will encourage lenders to continue to work with the mortgages on their books, but if they are in real trouble, they can dump the bad loans. This is critical, because this RTC needs to be open-ended so that institutions that need to dump their debts can do so, while those that do not, will not. So, initially, there couldn’t be a limit on how much debt the banks could dump, because truth be told, the full size and scope of the problem is not really known by the markets.
    5) Also, if any more business failures occur due to bad debt during this critical period, those bad debts automatically get put into the RTC.
    6) There needs to be a prohibition: No bailout to state and local governments that are currently losing property tax revenue. They became addicted like crack addicts to property values escalating. Now that they’re deflating, they need to scale back their workforces, commit to across-the-board salary cuts, or something. But it’s not the taxpayer’s problem. Without such a prohibition, this will become the next big bailout.
    7) Creation of Home Down-payment Accounts (HDA’s): Eliminate tax on interest on savings dedicated for home down-payments. HDA’s will encourage savings so that Americans who wish to save for a future home may do so tax-free. This will discourage borrowing and increase the amount of money individuals put down for a down payment.
    8) Finally, this only needs to be a temporary solution until the bad debts are settled and the mortgages are either foreclosed or taken out of the red. After which, the RTC would dissolve. With the smart credit standards, the elimination of Fannie and Freddie, and the creation of HDA’s, the taxpayer will be assured that this will not happen again.

    As far as the economic car wreck goes, this will allow traffic to move through while the pileup is cleared. And eventually, the traffic will be cleared. At the end of the day, the government gets out of the mortgage business, the bailout business, and a free market emerges. Everybody wins.


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