Left Flank

Stunned isn't how I feel, by far! Dejected, that's more like it! Whether one dices it, or swallows it whole, I just keep replaying Tony Soprano's elegy to the American golden age that launched his conversations with Dr. Melfi.

I'm starting to feel some rage, too. Time is a convenient remedy for those at the receiving end, but for those of us not feeling so generous?

Luigi Zingales calls on congressional action (probably not a sure thing, but it's all we got left! Short, that is, of alien benevolence!)

Here is where government intervention can help. Instead of pouring money to either side, the government should provide a standardized way to renegotiate, one that is both fast and fair.

Congress should pass a law that makes a recontracting option available to all homeowners living in a ZIP code where house prices dropped by more than 20 percent since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4 percent in the last two years.

How do we implement this? We have reliable measures of house price changes at the ZIP code level, thanks to two brilliant economists, Chip Case and Robert Shiller. By using the Case-Shiller real estate index, the recontracting option will reduce the face value of a mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property—exactly like in my hypothetical example above.

In exchange, however, the mortgage holder gets some of the equity value of the house at the time it is sold. Here's how it works: At the time of sale, the owner pays 50 percent of the difference between the selling price and the new value of the mortgage back to the mortgage holder. Stanford University successfully implemented a similar arrangement for its faculty, financing part of the house purchase in exchange for a fraction of the appreciation value at the time of sale.

The reason for this sharing of the benefits is twofold. First, it makes the renegotiation less appealing to homeowners, making it unattractive to those who don't need it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up half the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

The great benefit of this program is that it provides relief to distressed homeowners at no cost to the federal government and at the minimum possible cost for the mortgage holders. It will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions' balance sheets. But it will not resolve the problem of severe undercapitalization that these institutions are currently facing. For this, we need the second part of the plan.

(...)

The plan for Wall Street follows the same general concept: facilitating an efficient renegotiation. The key difference between the Main Street and Wall Street plans is in the ease of assessing the current value of the troubled assets. It is relatively easy to estimate the current value of a house by looking at the purchase price and at the intervening drop in value (per the Case-Shiller index). But for the complex assets based on the mortgage for that house? It's much harder. Instead, we are going to use a clever mechanism invented 20 years ago by a lawyer and economist named Lucian Bebchuk.

The core idea is to have Congress pass a law that sets up a form of prepackaged bankruptcy to allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are prespecified and banks could come out of it overnight. All that would be required is a signature from a federal judge. Unlike in the private sector, where the terms are generally agreed upon by the parties involved, the innovation here would be to have all the terms preset by the government, thereby speeding up the process. Firms that enter into this special bankruptcy would have their old equity holders wiped out and their existing debt (commercial paper and bonds) transformed into equity.

This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. They are close to being insolvent. By transforming all banks' debt into equity, this special Chapter 11 would make banks solvent and ready to lend again.

And, there's a lame-duck session that can be put on the calendar for all the congressional bums homeowners are going to fire on November 4, so that they can redeem their reputations!

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