Rescue the Economy from Financial Market Declines (REFMD) Plan
Surendra K. Kaushik
It is rapidly becoming evident that the financial system has nearly collapsed since the weekend of September 12 meeting at the Federal Reserve Bank of New York when Mr. Timothy Geithner greeted the assembled leaders of finance with the following words: “There is no political will for a federal bailout.” Treasury Secretary Henry Paulson had expressed the same view earlier that week. We knew by Sunday evening that indeed the Treasury and the Fed did not want to save the investment bank Lehman Brothers so it prepared for a bankruptcy protection the following Monday. At the same table Merrill Lynch and Bank of America made a merger deal. AIG was left hanging out with fellow financiers to invest some $75 billion in it. It was not to be and the Treasury and the Fed repeated their decision against bailout of AIG, for two days at least. By Wednesday evening we knew that the Fed would put $85 billion into AIG and take control of it. There have been many failures and mergers since then in the last six weeks.
Now we are witnessing a rapid cascading effect of the spreading financial freeze on the real economy. Jobs, incomes, production, investment and consumption have begun to show quick and sharp deterioration leading to a talk of deep recession and depression. Trust in financial markets is evaporating and safe insured money has become the most desired commodity to hold. The word and promise of the US government on the dollar is the only credit acceptable to markets.
To right its fateful and wrong decision not to save Lehman Brothers, the Federal government is now trying to “bailout” the credit system, and it hopes to rescue the economy from a fast approaching deep decline in the circular flow of the $15 trillion US economy, and by extension the world economy. The US Congress is not clear and it is speaking out with many voices on the rescue package authorizing the Treasury to purge the “toxic assets” from the balance sheets of those who are holding them. Apparently this is to restore acceptance of the word and the promise of private financiers among themselves so that the private credit circulation and allocation can resume their normal functioning.
The Treasury Asset Rescue Plan (TARP), bank capitalization program, full FDIC coverage of bank deposits, insurance coverage of money market mutual funds (MMMF), financial and non-financial commercial paper financing program of the Federal Reserve may cost the tax payer hundreds of billions of dollars in addition to a great expanded role of the Treasury and the Federal Reserve in the financial system. There is consideration of a new stimulus. In giving his support to a new stimulus Federal Reserve Chairman Ben Bernanke has suggested that every dollar of new spending or loss of tax revenue should maximize benefit to the economy.
One less costly way to rescue the economy from a potential severe economic downturn or depression is by avoiding a sharp drop in sales in fall 2008/Spring 2009 and a housing depression from creating a full blown economic depression. It keeps the financial and credit systems functioning in a normal deposit-credit-consumer-business circulation of money, credit, and equity investments in small, medium and large enterprises.
Refinance all houses and commercial real estate in foreclosure or default as of from January 1, 2007 to December 31, 2008. Federal and State government should participate in some proportions so that the plan is perceived as a collaborative effort between each State and the Federal government. The plan thus becomes a grassroots venture at the national level. Federal and State Funds should be used to take the loss of value between the outstanding mortgage balance and the actual (estimated) current market value. For example if a home is $50,000 below mortgage value then $15,000 could be absorbed by the state and $ 35,000 by the federal government.
Refinance the market value at FHA insured mortgage rate to keep the owner in the home, condo, office etc. The bank (lender-mortgage servicer) receives 100% liquidity of the loss. It can lend for new mortgages, car loans, personal loans, business loans, etc. The home owner gets an estimate of the market value (from the bank and a local realtor) at the end of the year each year and pays capital gains tax on the build up of the equity above the refinanced value. This will allow state and federal government to recover the cost of any net losses from properties not appreciating or totally abandoned. If the housing prices become stable and the housing market recovers as envisaged in this plan, the government could possibly make a profit in the form of additional tax revenue as real property begins to appreciate from Fall 2008 onwards.
Assuming a 25 percent decrease in home prices nationwide from 2007 to 2008, the estimated funds required initially to refinance and to re-liquefy the financial system maybe as little as $75, 000 per property for 10 million units = $75 billion (in the example below), which is far less than $ 700 billion approved to support the financial system. If it is 20 million units that cumulatively get in negative equity then the initial cost equals $150 billion, an amount far less than the TARP. This has the beauty of everyone being involved and it avoids a depression. Example: Mortgage Value $ 300,000 at 8% APR conventional mortgage. Home price decreases by 25 % to $225, 000 creating a loss of $75,000 to the bank. Refinance $ 225,000 @ 5% FHA mortgage rate. Consumer saves about $500 per month. Home owner lives in the home and the community. Bank gets $75,000 and lends it into the system. The mortgage asset on the balance sheet of the bank (mortgage servicer) continues to receive income from the new mortgage. The credit system keeps jobs, production, investment and consumption going as normal. Market allocates credit as usual.
A cost of $75 to $150 billion, much cheaper than the alternatives facing the US and world economies, may avoid a serious recession/depression. Furthermore, there is no net cost to the Federal and State governments over the next two to three years as the recovery rebuilds equity in homes and commercial properties. The principle of a market solution and the credit allocation function of financial markets is preserved and used to rebuild confidence and growth of GDP.
Surendra K. Kaushik is a professor of finance at the Lubin School of Business of Pace University in New York.
