Foreclosure and AIG

C. Northcote Parkinson said it best: (I paraphrase) the smaller the dollar value of a budgetary item, the more attention it gets from the decision makers. How true: we can all get our minds around the $150 million that were paid out in bonuses; we cannot begin to grasp the many trillions it may take to stabilize the banking system.

But focusing on the bonuses is a distraction from the main problem: the on going bailouts: There are two things wrong with the current approach: the wrong people are pursuing the wrong strategy.

Social Scientist have known for many years the problem of escalating commitment. Smart people commit funds to a project; the project turns out badly, so the smart people commit more funds to the same strategy in an attempt to recoup their losses. The men in charge of the current solution were in various ways associated with the roots of the problem. Larry Summers was instrumental in arguing for deregulation in the Clinton years; Tim Geithner, at the Federal Reserve Bank of New York, was responsible for the oversight of the institutions hat are collapsing around us. We need new minds to focus on the problem.

We also need a new approach. For every mortgage that is in trouble, there are many derivatives that hold a piece of that mortgage. But worse still, on each of those derivatives there are many, many insurance bets that have been made and that are held by AIG. There is not enough money in the universe to make AIG whole by taking those derivative derivatives off their hand. As Elizabeth Warren at a Harvard Public Meeting on the crisis said: Helping the Banks is looking at the wrong end of the dog. We need to look at the original mortgages. If they are made whole the pyramid of derivatives that rest on each of them will also be made whole. The way to do this is through the government entering into shared appreciation mortgages (SAMs) with the homeowner: the homeowners pay what they can, the government picks up the balance; both build up equity in the home which they will realize when the house is sold. This will be expensive. It has the advantages of simplicity: there is no need to unbundle complex derivatives; the mortgage handler simply goes on receiving the original income flow which is passed upstream to the derivative holders; the derivative holders are made whole. It keeps homeowners in their house; it keeps homeowners' children in their same schools; it maintains the stability of neighborhoods.

It will be expoensive and it will reward the good, the bad, the scoundrels, and the banks equally.

That will be a small price to pay to stop the disaster that faces us if we continue along the present path.

--
Martin G. Evans
Professor Emeritus of Organizational Behaviour
Rotman School of Management

617-876-3980
URL: www.rotman.utoronto.ca/~evans

Co-Editor Emeritus, M@n@gement

Shovel Ready and the issue of accessibility

The Governor and his advisors clearly do not understand what "shovel ready" means.

A shovel ready project should already have had the appropriate reviews carried out, including that for accessibility.

They also don not seem to understand the economic multiplier effect thatg we hope to achieve with stimulus funds. Money paid to analysts to examine whether or not a project meets the accessibility requirements is just as useful in generating demand in the market place as money spent on contractors building or retrofitting buildings.

In addition this is poor economics: doing a project right the first time is much cheaper than doing an upgrade later on.

The Never-Ending Bailout

Throwing more money at AIG represents escalating commitment to a losing course of action (The Never-Ending Bailout, New York Times,March 3, 2009: A22).

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?

The 2 percent solution

I heartily agree with Tom Cosgrove (The 2 percent solution, Boston Globe, March 2, 2009: A11). We need a progressive state income tax.

This could easily be achieved by amending the Constitution to say: "Massachusetts Income Tax will be a percentage of the Federal Income Tax paid; the percentage to be set by the General Court from time to time."

Then the Massachusetts tax form would be the shortest in the United States: just 3 or 4 lines indicating what you sent to the IRS, the appropriate percentage of that, the amount withheld and the amount due (to be paid or refunded). Think of the energy released into productive work during March and April of each year.

While we are about it let us fix the gas tax too. It should be set as a % of the wholesale price of gas. I would like to see a relatively high tax with 80% of the funds going to highways, bridges and rapid transit and 20% going as a tax rebate in some form to those at the bottom of the income scale.

Message to Regulators

Tyler Cowan's article on the bailout continues to focus simply on the problem of the banks (Message to Regulators: Bank Fix Needed Quickly, New York Times Business Section, March 1, 2009). He does not explore options that might make the banks whole and also help individual homeowners and their communities. The best option with this win-win characteristic would be the Shared Appreciation Mortgage (SAMs).

SAMs are the perfect instrument to bail out lenders, prevent foreclosures and restore confidence. In a SAM, a government agency would join with the distressed homeowner in meeting payments on the mortgage. There is no write-down so that lenders and derivative owners are made whole again. There is no foreclosure so that the individual homeowner stays in his home. There is no foreclosure so that neighborhoods are not hollowed out by a proliferation of empty homes.

There is risk to the government. As time goes by, the homeowner and the government build up equity in the home; the share of equity based on their proportionate contributions. There is however no guarantee that the total equity will exceed the homeowner's original purchase price before the house is eventually sold. In the best case scenario, both government and homeowner would recover their investments; in the worst case they would not. The risk of government losses might be reduced if the government part of the mortgage stayed with the house after an underwater sale, though that would reduce the attractiveness of the house to the new owner and consequently reduce the funds received by the seller. But this would work -- the government has infinite patience; early payoff is not a necessity.

Why don't we intensively discuss this solution, or something similar (as suggested by Andrew Caplin of New York University), as part of the recovery efforts that are being made?

Appeals Court Stops Release

It is clear that President Obama should grant refugee status to the 17 Uighurs still imprisoned at Guantanamo (Appeals Court Stops Release of 17 Detainees, New York Times, February 17, 2009: A18). We should not forget that there are also 5 Uighurs languishing in a refugee camp in Albania who were sent there under George W. Bush's watch. They too should be brought back and released in the United States.

Colin Powell famously said: “If it’s broken, you own it.” We have broken the lives of these Uighurs. We need to do all we can to fix them, not deport them to Albania, nor keep them locked up in Guantanamo.

Bring them to the United States now.

Harvard in Alston

Harvard is wrong (Harvard slows work on Alston complex, Boston Globe, February 19, 2009: A1, A4).

Harvard is the one institution in the Commonwealth that can afford the counter-cyclical spending we need if we are to recover from the current economic crisis. Harvard should put its resources into helping the recovery not timidly draw back behind its Cambridge walls.

Being altruistic is not the only reason that Harvard should press on with the development. The Science Complex will cost a lot less now than it would in a few years time after the recovery is in full swing.

Take the risk Harvard! Spend some of that endowment -- it is only about 4% -- for the good of Harvard, the region, and the country.

Sent to Boston Globe

Playmobile

Ms Winfrey claims that the purpose of Playmobile toys is "to familiarize the child with the realities of life" (All Fun and Games, Till You Get Detained, New York Times, February 16, 2009: B5). I find most reprehensible those sets that include both Dinosaurs (not dinosaur remains) and humans.

That is very much the wrong message to give.

Sent to New York Times