The problem with Treasury Secretary Hank Paulson’s $700 billion bailout plan is that it is aimed at the wrong market.
Instead of addressing what Paulson himself calls the root problem — the housing crisis and the failing mortgages originated in the primary market — Paulson’s plan is aimed at the financial instruments of the secondary market, which involve the repackaging of mortgages made in the primary market and the ultimate creation of debt securities backed by those mortgages.
While the secondary market for mortgage-backed securities is nothing short of a mess, the secondary market is failing because of failures in the primary market. Paulson’s congressional testimony reveals that he knows as much, yet his solution is not aimed at dealing with the borrower-level problem in the primary market.
Paulson’s approach would likely inspire more market confidence if it were aimed at the right market. Its misplaced focus on the secondary market also leaves the taxpayer unprotected.
For example, one of Paulson’s proposals for buying up distressed securities is a reverse auction in order to establish prices for these secondary market debt instruments. Once that price is established, the government will presumably buy each debt security backed by a pool of mortgages at the price established by the auction.
But there are tens of thousands of different pools of mortgages against which hundreds of thousands of debt instruments have been issued, all of which have different characteristics. Is Paulson going to undertake a reverse auction for each different type of debt security? Is that even possible? It would take 100 years to do so, and the ultimate result would provide neither stability nor transparency. Paulson will invariably have to undertake an ad-hoc approach in the face of random bidding with no hope of real success, similar to what he has done so far in addressing this financial crisis.
Instead of providing a general government bailout of mortgage-related securities as a means to addressing the liquidity crisis, the government should consider guaranteeing — for a price and under certain conditions — the principal balance of each troubled mortgage held by the servicers who administer mortgage-backed security pools. This would create a “floor” on the value of each troubled mortgage originated in the primary market, thereby creating a floor on the value of the related secondary market mortgage-backed security, thereby helping to eliminate valuation uncertainty, and restoring confidence and liquidity to the market.
So that borrowers also benefit, the government guaranty would only be provided if the servicer of the mortgage loan provided to the non-performing borrower a better set of terms (i.e., reduce the principal balance of the loan to some extent and offered the borrower a better fixed interest rate). In addition, the government would charge a guarantee fee.
