My Modest Proposal

I have a proposal for fixing our current financial mess.

(For a background on how we got into this situation in the first place, I advise you to read this, which is definitely the best summation I've read so far. If you have time, listen to this TAL episode, which is a very good explanation of mortgages, mortgage-backed-securities and predatory lending.)

When I got my student loan, it was a government-backed deal. The financial institutions give out the student loans, while the government insures those loans in case of default. Because the loan is insured, the financial institution is  not at any risk and can therefore give out the loan with a nice, low interest rate.

My proposal is based on this idea. The current mess is being caused almost exclusively by home owners defaulting on their mortgages. If the government insures all home mortgages in the United States against default, no financial institution holding the mortgages (or mortgage-backed securities) is at any risk and therefore is in no danger of taking a financial hit. The sub-prime mortgages, all together, total somewhere in the neighborhood of $150 billion, far less than the $700 billion Bernake and Paulson are asking for.

Under this plan, if someone faces defaulting on their loan, they can avoid foreclosure by renegotiating their loan with a bankruptcy judge (you know, those people who solve these problems all day long at the micro-level — the true experts in this field). The bankruptcy judge will have at his disposal a giant pool of money from which to supplement what the troubled home owner can actually pay, so the bank is getting the proper amount. This prevents the foreclosure. And preventing housing foreclosure should be the first and foremost priority because that is the root of the problem. End the foreclosures, end the crisis.

This is a bottom-up approach which directly deals with the cause of the problem. It absolutely will work.  It is not a top-down approach, the one they are currently pushing, a plan which they cannot explain and certainly cannot guarantee.

What do you think? Tell me in the comments.

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UPDATE:

Looks like someone beat me to this suggestion. Nouriel Roubini, author of Bailouts or Bail-ins? Responding to Financial Crises in Emerging Economies and a professor at the  Stern School of Business, offers:

HOME (Home Owners’ Mortgage Enterprise): A 10 Step Plan to Resolve the Financial Crisis

I have also argued that, in order to resolve this financial crisis it is not enough to take the bad/toxic assets off the balance sheet of the financial institutions (a new RTC); it is also necessary and fundamental to reduce the debt overhang of millions of insolvent households via a significant debt reduction on their mortgages (an HOLC program like the one that was implement during the Great Depression); and also recapitalize undercapitalized banks with public capital in the form of preferred shares (as the RFC did with 4000 banks during the Great Depression). An RTC scheme without an HOLC and RFC component would not resolve two fundamental problems: millions of households are insolvent and unable to service their mortgages; the financial system is vastly undercapitalized and needs capital to avoid an ugly credit crunch and to foster new credit creation that is needed for future growth.

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