On A Way Forward, Or, Practical “Subprime Crisis” Solutions

We had a lively discussion last week regarding the causes and possible future of the “subprime crisis” that is on everyone’s lips these days.

Having examined the sources of the problem, and noting the lack of holistic thinking about how things might be resolved, I’ve taken it upon myself to come forward with an idea that can actually get at the root causes of today’s difficulties…and do it in a way that offers a potential “win-win-win” outcome for homeowners, investors—and the taxpayer.

Paying attention, Presidential candidates?

Good—because time is short, and we need to get to work.

For today’s solution to make sense, we, like Sherman and Peabody, need to make use of the “WABAC Machine”. We’ll set the time dial to the late 1980s, and we’ll set the location as the headquarters of the Resolution Trust Corporation.

What we’d find is a governmental organization established at the height of the “savings and loan crisis” of the 1980s. The savings and loan companies had made a series of bad real estate investments (much like today), and many had already entered or were in danger of bankruptcy.

Perhaps not surprisingly, many of the same names we recognize today from the world of politics were also to be found “doing bidness” at the time of the birth of the RTC…and if you look it up, you’ll find such luminaries as John McCain, Barney Frank, and even Neil Bush doing things that they today wish we would forget.

In fact, there were so many people doing things they wish we would forget that the RTC was needed to find buyers for all the bankrupt savings and loans that had piled up across the nation. The way this was accomplished was to use regulatory pressure to politely force the bankrupt to accept offers from the more solvent.

As a result, the Silverados of the world vanished, and Keating Five became part of the lexicon.

And with the history lesson complete, let’s scoot on back to the “WABAC” machine and return to the present day, shall we?

Those who participated in our bond insurance discussion (and many who didn’t) may recognize that the biggest problem currently affecting the American financial sector (and beyond) is an inability to accurately determine the exact value of various financial assets.

As you may recall, we noted that one form of these assets are “collateralized debt obligations” (CDOs), which are fundamentally income streams from loans backed by real estate collateral. The original debt was incurred in the form of mortgages or equity loans. The current owners of these assets are not the originating lenders; but instead investors scattered across the planet which have purchased bundles of these loans, a process known as “securitization”.

Because there is a disconnect between an investor in Singapore who purchased a CDO and the borrowers back in the USA who are supposed to be making the payments; it is at the moment impossible to determine with any accuracy the actual value of any particular CDO. In other words, if you invested in loans and you don’t know who might fail to pay, how can you know what your investment is worth?

Lenders, regulators, and investors prefer clarity above all else. In a perfect world, borrowers who might be in trouble would promptly contact lenders to initiate a “workout”. Then everybody would know the status of every individual CUSIP, and life would again return to a state of near normality. (CUSIP is a fancy technical term: each individual loan that makes up a CDO is known colloquially as a CUSIP, and has a CUSIP registration number. Other types of debt instruments, such as bonds, also use the CUSIP registration process.)

But how is that supposed to happen when neither the borrower nor the investor know each other?

That’s where this proposal comes in.

Imagine, if you will, a new Resolution Trust Company that would be chartered with the purpose of creating a “clearinghouse” where investors and borrowers could reach accommodation—and where the status of individual CUSIPs could be determined, registered, made known to participating investors, and, in a privacy protected form, to the public at large.

On the investor side, the process would begin with each investor voluntarily “registering” their CDOs with the new RTC. The registration process would determine exactly which CUSIPs are associated with every registered CDO, and this data would be maintained in a public database.

On the borrower side, an advertising campaign that might look like the ads you see for “credit counseling” services would be run by the RTC…something like: “Are you facing foreclosure? We can help to keep you in your home. Call 800 NO FORECLOSE today”.

The RTC would be empowered to act under a limited power of attorney on behalf of the registered investors and would have the authority to negotiate payment arrangements that might include extending the term of the loans at lower payments, some form of delay on “teaser rate” ARM adjustments, or converting the ARM to a fixed-rate loan—or any combination of the above, as warranted.

In extraordinary cases, the RTC could facilitate direct negotiations between homeowners and investors—and in cases where the home is “under water” (the amount owed is greater than the home’s value) such negotiations will be needed.

Every day, as more and more homeowners call in and the status of their loans is determined (“current—no issues”, “default”, “in processing”, “resolution unsuccessful”, “unknown”, and “resolved” are examples of categories to which the loans might be assigned) they can be matched to their registered CUSIP. As the database fills, this creates the clarity that allows more accurate valuation of the CDOs associated with the CUSIPs…which should be the necessary first step in resolving the valuation issue that’s currently choking up the financial markets.

By publicly posting the loan status and the CUSIP number-without other personally identifiable information-it would be possible, to some degree, to protect the homeowner’s personal credit information from public view, while still offering an “open and public” assessment by an independent third party of the CDO to which the CUSIPs are associated…which means private financing can return to the mortgage market with renewed confidence in what they’re buying…which should also have a positive affect on the stock prices of some of the most beaten down companies in today’s market.

At the same time, as the foreclosure rate declines (if this proposal were successful, that could happen rather quickly) less surplus real estate appears on the market…making investment in land and homebuilding once again a reasonable business proposition. Fewer foreclosures also means less decline in the value of affected neighborhoods, which means the neighbors benefit as well.

All of this could be funded by a registration fee per CUSIP (or based on the amount of the loan) charged to the investors that covers the cost of the RTC’s operations.

You might have noticed that I have not referenced what might be the most daunting problem a new RTC might face: the problem of large loans for large projects. How does the $30,000,000 loan to the Florida land developer who has a half-finished condo complex as collateral get worked out?

I have no idea, but it seems to me that the role of the RTC might be best served by doing the high-volume, “cookie-cutter”, single-family home resolutions (and similar duplex, triplex, and other “small unit” properties), leaving the most complex solutions to be negotiated directly between borrower and investor, with loan servicers and bond insurers charged with facilitating resolutions of these problems on their own.

If solutions can’t be found, the bond insurers are on the hook for the income stream, but if the bond insurers default the investors will get nothing (even when they do get paid the cross-ownership is so convoluted that as we move through the process some of the investors will potentially have to work out deals with themselves), so everyone involved should already-or soon will-have what R. Lee Ermey once famously referred to as “the proper motivation”.

So with all that said, what do we have?

We have a proposal that creates a new RTC for the purpose of “clearing” CUSIPs, which allows CDOs associated with those CUSIPs to be valuated, which creates the conditions for private investment to return to the mortgage market.

We do this with the only cost to the taxpayer being limited to incidental costs (registration fees not collectable, and the cost of enacting the legislation, for example) and the burden of bearing the upfront costs of establishing the RTC and launching the ad campaign—which presumably will be recovered as the process moves along to conclusion.

We also do this without changing the “risk profile” of the loan portfolios held by Fannie Mae and Freddie Mac—a potentially huge benefit to the taxpayer.

The investors, bond insurers and loan servicers win because it suddenly becomes possible to credibly and independently valuate the CDOs, communities win if foreclosures return to normal levels, and homeowners get to keep their homes and credit ratings…and the larger economy benefits as the CDO market, for the first time, feels the “cleansing effect of sunshine” brought on by greater disclosure.

And to top it all off, the “moral cost” of the bad choices made are borne by the involved parties, rather than the American taxpayer: homeowners who made bad loan choices still have to pay off the loans, even if it takes longer than they originally thought…investors will lose or have delayed some portion of their interest income…and the best part—investors and “predatory lenders” who foolishly participated in sketchy loans to currently “under water” borrowers will probably lose some or all of the value of those investments as the true state of their CDO portfolio becomes known to the market at large.