Two months ago, hardly anyone knew of credit default swaps, commercial paper, mortgage backed securities, and mark to market accounting. Now, guys like Hank Paulson and Ben Bernanke are household names right up there with Barack Obama and John McCain. It seems that everyone in America woke up a new financial guru because of our current financial meltdown.
It is not hard to find an opinion as to who is at fault or to hear how we ended up in this mess.
As a matter of fact, a prevailing theme is how the government and big banks screwed everyone. “Send them all to Jail”, is a common outcry. Of course, “Them” is all the fat-cats on Wall Street who got rich at the tax-payers expense. While an element of that sentiment is probably true and healthy, most would agree, that the root of the problem is very simple and mostly removed from Wall Street and Capitol Hill. People took out loans that were leveraged against property that were neither affordable, nor was the collateral worth the loan amount. It is really that simple. The situation is not really any different than getting 100% financing on a new vehicle that you drive off the lot. Everyone knows that when you purchase a brand new vehicle, the “value” sinks that minute it becomes “used”.
How is that any different than buying a home? Prices go up. Prices go down. Sometimes people buy a McMansion they can’t afford and sometimes people by a Mercedes they can’t afford. When this happens, there
is was a process for handling each situation. Our meltdown is a function of too many people not being able to afford too many McMansions (ok, they weren’t all McMansions – but that is a relative term).
What Should we do, Then?
In my humble, simplistic opinion, what we desperately need is a simple solution for people who borrowed too much money and made a bad financial home-buying decisions. Forget Wall Street, Bail Outs, deflation, hyper-inflation, and Elections for a minute. Let’s just cut out the confusion and decree that if you borrowed money that you cannot afford, it will be paid back sometime, somehow. And the way that we are going to do it is called a promissory note. Here’s how it works. If you bought a house for $250,000 and can not afford it then you need to sell it. If you can’t get what you paid for it, then you owe the difference to your lender(s). The lender(s) can either make you liable for the entire difference, a portion of the difference, or none of the difference. The result is a simple function of your ability to negotiate and your lenders process for dealing with this particular type of loss mitigation.
Here is where the Government could help.
The Government could inject capital by purchasing these loans. In essence these promissory notes would become unsecured lines of credit against each individual borrower no different than a credit card. These loans would probably have fairly high default rates. The Government should offer to pay a fair price for these loans. After a bank reaches an agreement with a distressed borrower, the government would offer to pay a fair amount for the default deficiency note given that the note has a good chance of being a non-performer. Now here is where it gets appealing to the home-owner. Over time, the banks would learn that by charging a lesser amount on promissory notes vs. total deficiency, the higher chance that they would have to collect on the note. Therefore, the lower percentage notes would sell for a higher amount. Therefore, the banks would be incentified to strike deals with borrowers that would perform.
The bank would be incentified to do these transactions because they will recoup funds from the sale of the real property and they would either recoup additional funds by selling the promissory note or receive additional revenue from the promissory note. Either way, it’s much better than the quagmire that they are in right now. Many may be wondering why the borrower would want to do this. Why wouldn’t they just walk away. Well, to put it simply, they could. They could just walk away. And the cure for that process is foreclosure with a resulting deficiency judgment. Compare that with an affordable, low interest, long term, promissory note.