Do We Look Stupid?

[For the solution without the background, click here.]

Our president and members of Congress think we’re stupid. They think we can’t do simple arithmetic. They haven’t said so in so many words, but actions speak louder than words.

Secretary of the Treasury Paulson and Fed Chief Bernanke, who are most definitely not stupid, say we have a $700 billion problem. Hardly anyone has questioned that number. Those few who do are just as uncertain as they are. No one with any expertise has estimated the size of the problem at anything less than several hundred billion dollars.

On Wall Street, our problems are a bad-asset logjam and a resulting credit crunch. No private party will buy securities backed by bad mortgages because the borrowers can’t pay and no one knows what the homes used as collateral are worth. So credit is tight because we’ve got hundreds of billions locked up in untradeable mortgages and mortgage-backed securities.

Main Street has related problems. Many of our towns and parts of our cities are dying because of foreclosures. Many people have lost their homes, and many more are about to lose them. Even now, the estimate is 2 million homes. Many of those homes are empty, or soon will be, bringing neglect, crime and blight into erstwhile good neighborhoods. Lower prices and lower home values follow, even for homeowners still making their payments.

New buyers aren’t interested in those homes because no one knows what they’re worth. Buyers think prices will drop if they just wait. Meanwhile, neighborhoods continue to decay.

All these problems have a single cause: the bursting of the housing bubble. With prices for homes in free fall, there are few buyers, so no one knows what homes are worth. Because homes are the only collateral for mortgages, and because borrowers are in default, no one is buying the mortgages and mortgage-backed securities either.

So how, pray tell, will cutting financial executives’ pay solve any part of these problems? There is no logical, arithmetic, or rational relationship between CEOs’ pay and any of them.

Even if there were, the numbers don’t work. Let’s make some wildly extravagant guesses about the aggregate amount of excess CEO pay. Let say there are 100 financial institutions holding bad mortgages or mortgage-backed securities in amounts big enough to matter. Now let’s say each CEO makes $250 million (most make, at the most, in the tens of millions) and that every penny of that pay is excessive. Multiply those numbers together, and you get $ 25 billion dollars—about 3.6 % of our problem.

How in the hell is saving that kind of money going to solve our $700 billion problem, even in our wild overestimate, and even if we save that much every year? (The crisis is only supposed to last two years at most; at least that’s how long Paulson has asked for Treasury to have extraordinary authority.)

The answer is: it’s not. What our political friends have done is what bad politicians always do. They distract us from the task at hand to push what they can sell; they shirk the hard work of selling a solution that might actually work.

The Republicans have practiced this trick for years with abortion, homosexual marriage, guns and religion. Now the Democrats are doing it, too. Both parties think we are so dumb, and so mad at overpaid CEOs, that if they just cut the CEOs’ pay, we’ll all go away and let them get back to destroying our democracy and economy with their blunders.

Besides the fact that Secretary Paulson wants absolute power for himself and his successors, there are two problems with the proposed bailout. The first problem is that Treasury is likely to overpay for the bad assets. If it overpays by just five percent—an amount easily lost through miscalculation in even normal transactions—the loss will exceed our wildly high estimate of CEOs’ excess pay.

The second problem is our neighborhoods. Even if Paulson performs the impossible feat of perfectly nailing the uncertain value of every bad mortgage and security he buys in our name, his scheme won’t do anything for Main Street. It won’t stop foreclosures. It won’t put people back in their homes. And it won’t stop the massive decay of our towns and cities, or the part of our housing-price free fall caused by foreclosures. It won’t even begin to address the root of all of our problems: the free fall in housing prices.

There is only one way to solve these problems for real. That’s to put a floor under home prices and stop the hemorrhaging on Main Street. If that happens, the problems on Wall Street will take care of themselves.

All it would take is three simple steps. First, impose a moratorium on foreclosures. Second, revise mortgages and loans in foreclosure (and those already foreclosed, for a reasonable period) to require payments that borrowers can actually make. Third, in exchange for the loss of agreed but impossible payments (which are not now being made), give lenders an interest in homes’ future appreciation, when sold. Finally, calculate the floor “value” of every mortgage based on the sustainable payments that the homeowner is now able to make.

Voila! The mortgage and security that bundles it has an easily calculable, precise floor value: the stream of the borrower’s now-sustainable payments, discounted to present value and further discounted by the usual risk of default. It also has an upside above the floor, measured by the lender’s interest in the home’s future appreciation.

Now the mortgages and securities can trade. In fact, a robust private market is likely to develop, as private parties speculate on the upside, i.e., the future of home prices and home sales in particular markets. [For a particular variant of this general solution, with more detail, click here.]

This solution won’t cure the part of the home-price free fall caused by the burst housing bubble alone. But it will give every home mortgage a calculable minimum value, allowing trading to begin. And it will stop the destruction of neighborhoods due to foreclosures and empty homes.

It may take some time for home prices to stabilize. But every mortgage will have a realistic minimum value, quite apart from the price or value of the home. Now it will represent an income stream from a borrower willing and able to pay, rather than a borrower in default, or a borrow who (in an anti-deficiency state) has walked away from the home and given the lender the keys to an empty home in a decaying neighborhood.

As mortgages go, so go the securities and credit-default swaps that depend on them. They will all have minimum values or maximum exposure, motivating private parties to trade in them again. The asset logjam and credit crunch will clear. And they will do so without massive expenditures of taxpayers’ money, maybe without any.

But the president’s men and Congress want none of that. They want taxpayers to bail out Wall Street, leaving carnage on Main Street. But worse than that, they want us to believe that you can solve the difficult problems on Wall Street (the asset logjam and credit crunch) without even addressing the underling problem: the uncertainty in home values on Main Street from which the uncertainty in all the other asset values springs.

Still worse, the president’s men and Congress think they can get us to give them absolute power to implement their non-solution by distracting us with the irrelevancy of cutting executives’ pay. They must really think we’re stupid.

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