Bailing out the Bailout

Congress has approved $700 million of bailout money.  Henry Paulson keeps changing his mind about what he wants to do with it.  He has focused almost entirely on institutional fixes.  Maybe I’m missing something, but it seems to me that the financial system currently is leaking below the waterline.  What we need to do is fix the leak.  Here’s how I think we should do it:

The Federal government should step in immediately and guarantee the full monthly payment of mortgages that are in default.  It should negotiate the best deal it can with homeowners and then pay the difference to mortgage holders, making them whole.

This will cost about $200 billion – big number but much less than $700 billion.  It will immediately cause the non-performing mortgage-backed securities whose collapse triggered this crisis to start performing again.  As they re-inflate, they will bring with them the attached loans and derivatives back with them.  This in turn will resuscitate the balance sheets of the banks and other financial institutions that are now lining up for government handouts.

In exchange for this investment, the government should get warrants convertible at today’s stock price into 20% of the stock of every financial institution that holds or lent against sub-prime-backed securities.  That will be a significant, but non-fatal, haircut for stockholders and give taxpayers an appropriate return.  It might even let us take a chunk out of the national debt someday.

This is similar to the plan advanced by FDIC Chairwoman Sheila Bair.  However, she proposes to have the government only guarantee mortgages that have been renegotiated to government-specified terms. The problem with this is that it will leave the value of the now-defunct securities in doubt, and therefore is not likely to resuscitate the market.

I do think, however, that holders of ARMs that have not yet gone into default should be required to renegotiate them down to reset levels at which borrowers can remain current.  That will keep the crisis from getting any worse.

Would this result in an undeserved windfall to a bunch of borrowers who made unwise decisions.  Absolutely.  I don’t care, and neither should you.  The issue here is not “preventing foreclosures.”  It’s plugging a gaping whole in the financial system and letting that system right itself so that it can support the economy.  As a nation, we all enjoyed 5 years of unprecedented and undeserved prosperity on the back of an artificial run-up in housing prices.  There has to be a reckoning for that.  One thing that reckoning will not be is fair. And we should all be fine with that as long as we get recovery.

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