Replacing Mystery Meat Mortgages with USA Prime

New York City - In previous posts I have written about the advantages of a low interest, 4% USA mortgage to make mortgages again affordable and reduce the risk of further defaults.  In the last couple days a proposal has been emerging that would not only accomplish this but also go a long way to restoring the health of our financial system.  Here's my version of how it would work.

Recall what ails us. Back in 2007, borrowers of high interest mortgages began to miss payments and then default.  If this were the 1990s, banks might have seen their revenues drop, stopped buying such paper and moved on.  However, in 2008, strict mark-to-market rules created by the Sarbanes Oxley law, turned rising defaults into an instant crisis by requiring holders of the securities to reprice them every quarter and take any differences as an instant loss.  Huge paper losses quickly threatened the solvency of America's largest financial institutions.  The Bush Administration after first promising to buy up the "troubled" assets through the TARP instead injected capital to make up for the paper losses.  Why the change of course?  Mainly because when pressed, Treasury could not figure out how to price the hard-to-value assets. (While markets can value long term  government bonds, pricing a 30 year security with an unknown default rate is akin to figuring out the chances of your home team winning the Superbowl in 30 years.  You can guess but you can't know.)

One solution, of course, might have been to relax the Sarbox mark-to-market rules for long term securities where there is no market.  How, after all, are investors supposed to reprice something with no active market that they might choose to hold to maturity.  Senator Dodd is said to favor changing the rule.  But others argued against and the rule remained in force.

Fast forward to this week.  Plans to offload the hard-to-value assets into an aggregator bank have run up against the same old problem of how to value them not to mention the cost of buying them up.

So here's the proposal. 

The difficulty of valuing mortgage backed securities and their derivatives largely stems from their unknown risk of default, lack of conformity and lack of a common guarantee.  Uncertainty, in turn lowers their value.  What better way to solve the problem, therefore, than to retire these mystery meat mortgages and securities and replace them with standardized, low interest, and thus low default, government guaranteed alternatives.

Under the plan, the government would guarantee a new low interest, standardized mortgage.  Old, complex mortgages would be swapped out for the new ones.  In this way, a substantial portion of the "troubled", read hard-to-value mortgages could be replaced with transparent, healthy ones.  The loss of juicy returns to investors owning the mystery meat would be more than compensated for by the lower risk of owning USA Prime.

There is no reason the government should have to make huge outlays to carry out this plan.  The government guarantee would make these securities attractive to private investors including those holding the mystery meat today.  Borrowers with equity in their home would readily swap high rate mortgages for the USA mortgage.  Interested banks might want to make the swaps at a wholesale level.  A provision that you can only finance up to 80 or 90% of market value would protect taxpayers but prohibit underwater borrowers from making the swap.  However, banks could be incented to make the swap at a discount as an improvement on foreclosure that would also enable people to stay in their homes.

What would the plan accomplish?  It would create transparency in the market, promote price discovery and minimize losses of the banks while providing Treasury with a healthy buffer of 10-20% against losses.

Ultimately, this proposal not only can replace mystery meat mortgages and securities with USA Prime but also keep people in thier homes and free up a great deal of demand in the economy for years to come thanks to lower payments for American families.

Stay tuned.