Jack M. Guttentag The Mortgage Professor

The Treasury and Federal Reserve to date have doused financial fires at Bear Stearns, Fannie Mae and Freddie Mac, and AIG, taking a tough line in every case to protect taxpayers. In the case of AIG, for example, the government has the right to acquire a major equity interest in the firm as a quid pro quo for a loan of $85 billion, and the CEO was forced out.

But now the government has decided that, rather than wait for new fires to arise -- which could easily swamp their ability to respond -- they will wet down the forest. Their plan for doing this would spread assistance through the market with no quid pro quo at all.

Their thinking is that the tinder underlying the fires is the overhang of non-performing mortgages and mortgage securities in the portfolios of institutions, and that the way to dampen the forest is to have the government buy substantial amounts of them; $700 billion is the figure mentioned, but that could only be round one. They are planning this program with unprecedented haste.

This mammoth transaction, which could have ramifications lasting decades, is a disaster in the making. It will dampen only patches of the forest -- and not necessarily the right patches. It will provide taxpayer gifts to every selling firm, with no quid pro quo. This in turn will create irresistible political pressures to provide equivalent giveaways to distressed borrowers -- but only those fortunate enough to find that the government now owns their mortgage. And since there are no existing institutions to execute the plan, implementation could become the boondoggle of the century.

A far better approach is to allow mortgages and mortgage securities to be used as collateral for loans. This would extend the traditional lender-of-last-resort function --which has already been extended to cover investment banks and insurance companies -- to everyone who can post acceptable collateral.

This alternative approach of extending loan facilities directly targets those with the greatest cash needs. Further, there would be no giveaways; on the contrary, the government would generate a profit that could be used to assist borrowers in distress. In addition, this approach could be implemented through the existing Federal Home Loan Banks; lending on the basis of mortgage collateral is what they do.

The problem that the government is trying to address is that solvent firms subject to bad news can't meet their cash needs because a) assets that would be saleable in normal times are not saleable today and b) because of the bad news, nobody will lend to them.

In principle, government relief could focus on making assets marketable, or on making loans available to the firms that need them. The government's proposal is directed to the first, when it should be directed to the second.

From press reports and the Treasury's Fact Sheet released Sept. 20, the government plans to employ a series of auctions, each auction covering assets meeting some specified characteristics; the one example given is loans that are delinquent but not in default. Potential sellers would bid the price they were willing to accept. Government would array the bids with the lowest-price bid at the top, and accept all those that add up to the total amount committed to the auction.

Who Benefits

Bids would have to be expressed as a percent of face value, which has little relationship to market value. The firms that would benefit the most are those with the worst assets that meet the eligibility requirements of the auction. There is no reason to believe that these firms are also the ones most likely to suffer a cash shortage that would threaten their survival.

After the auction, the government would own the mortgages that it had purchased. Because it has gifted the sellers, it will be under enormous pressure to gift the borrowers as well. But if it does this, a chasm will open between the treatment of those borrowers and the borrowers who were left behind because their mortgages were not sold. From the borrowers' standpoint, whether they are in one category or the other is completely arbitrary.

It is unlikely that the government could resist the political pressure to gift its borrowers. Would it require other investors to provide the same breaks to their borrowers? Or would the government feel compelled to go back into the market and buy up the rest of the loans? These are frightening possibilities.

A loan program will provide cash to firms with acceptable collateral, rather than to firms that bid successfully in an auction. Further, following traditional lender-of-last-resort practice, the government would charge a penalty interest rate high enough to discourage borrowing for the purpose of relending at a profit. The government would make the profit, since the loan rates would substantially exceed the government's cost of funds. This profit could be allocated to the HOPE NOW alliance for use in facilitating contract modifications of mortgages in distress -- all mortgages in distress -- or to other similar programs.

The Federal Home Loan Banks have been in the business of making loans collateralized by mortgages since 1935, and they have all the required systems, including systems for valuing and safeguarding mortgage collateral. Under existing rules, the banks lend only to their members. Under the rules applicable to the new program, they would lend to a larger list, which should include any firm (including hedge funds and foreign-based firms) that can post collateral acceptable to the banks. To move this program forward, the banks require only the new rules specifying authorized sellers and acceptable collateral, plus incremental funding.

A colleague who read a draft of this article commented that the problem the government is attempting to solve is not a shortage of cash but a shortage of capital, which in turn leads to an inability to borrow.

There is merit to this view, but as a plan to replenish depleted capital, the proposal has even less value than as a plan to replenish depleted cash. If a firm needs $100 million of capital to be viewed as credit-worthy by the market, the way to provide it is in exchange for shares or warrants to buy shares. Providing it by purchasing assets for $100 million more than the assets are worth is not only sloppy but it also leaves the government with nothing of value.