Tuesday, October 28, 2008

Thinking at the margin


The good folks over at Calculate Risk have two scary looking calculations, related to negative home equity.

Since this is a solutions-oriented blog (hopefully), here's an idea to help fear from becoming a policy paralytic.

When you have a problem that appears too large or too complex to solve, try solving a smaller problem first.


One way to dice the problem is to only help at the margin. As long as there are people with jobs and incomes, then LTV is not as important, in the short and mid-term.

Focus, instead, on those loans that are at default because of a loss of income (job) or because of loan terms that could be sensibly restructured.

If you start early and make a point of not putting up perverse incentives by allowing some loans to go into collection, you can "manage" this problem, with far less resources than the worst estimates of the "total problem".

If default rates, at their worst, range up to 18% (guessed twice the projected unemployment rate in a severe slowdown) and maybe 4% are not able to be mitigated, then we are talking about addressing 14% of the entire problem with public money. That might be cut in half, if it can be shared with lenders 50/50. That assistance can be spread out over time, so the huge cash outlays are not needed all at once. The realization of the rest of the losses can get spread out over an even longer period of time, for many loans.

If there is some debt-for-equity swap done as part of the distressed-mortgage deal, then the long-term expectations also get successfully managed, because any stabilization or bottoming of the housing markets will immediately be taken as the upswing of a "virtuous circle", in which "worthless" debt-for-equity bets look like they may pay off, thereby boosting confidence in the lenders that offered those terms.

A slow adjustment is sensible and workable. Belief that "free markets work" or in letting the housing markets going through an unattended, fierce, and rapid adjustment that overshoots, even, is probably not the best option for the general welfare ...

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