The insurance contracts held by AIG are many multiples of the mortgages owed by homeowners, because many entities took out insurance policies on these basic mortgages and on the derivatives into which they were sliced. To bailout AIG will require much more money than the amount currently committed for bank bailouts.
We really need some new thinking in Washington.
If every mortgage has multiple derivatives associated with it, then the way to detoxify all these derivatives is to detoxify the underlying mortgage. The current attempt to write down mortgages is difficult to accomplish because all the owners of the mortgages and its derivatives have to agree on such a step.
The solution is to make the mortgages whole. This can simply be done through the government joining the stressed homeowner in a Shared Appreciation Mortgage based on the existing face value of the mortgage. For this only the homeowner and the government have to come to agreement. The mortgage holder and all the parties to the derivatives do not have to be involved because their income stream is unaffected. The homeowner pays what he or she can, the government picks up the balance. Going forward as the mortgage is paid down, both the homeowner and the government build up equity. When house prices recover and the house is sold, government and homeowner get their proportionate shares of the proceeds based upon their proportionate contributions.
The risk is that the government may face losses if house prices do not recover; but the government can continue to hold its mortgage if the house is sold at less than the value of the mortgage -- governments in this situation have infinite patience.
The Shared Appreciation Mortgage has several advantages: the mortgage and derivative holders are made whole; the mortgage holder does not have to go through the costs of foreclosure; and the neighborhood is not scarred by empty, foreclosed houses.
What are we waiting for?