De-Toxifying Those Toxic Assets

We’ve all heard the term, ad nauseam, lately: “toxic assets.” There is no specific definition. People use the term to refer, generally, to any mortgages that have failed, and to mortgage-backed securities that have lost significant value. It is those toxic assets that are causing so much consternation with regard to all of the plans that have been developed thus far to address the mortgage crisis. The reason is that none of those plans tries to fix the underlying problems that have made the assets toxic. Instead, they simply shift the problem from one place to another – typically from the balance sheets of private banks to government accounts supported by taxpayers. That is not a solution; it is an accounting gimmick.

By detoxifying the toxic assets, we achieve several benefits. First – and this is really the lynchpin for the whole system – we reduce borrowers’ payments to sustainable levels. By reducing payments to a stable level that borrowers can afford, we make it much more likely that borrowers will avoid default and continue to make timely payments on their mortgages. That, in turn, means that we will slow the wave of foreclosures that has driven down property prices so far so quickly. It will also slow or even halt the precipitous decline in the value of assets based on those mortgages. If we can effectively detoxify the toxic assets then we don’t have to play a shell game that simply shifts bad assets from one place to another – we can actually mitigate this disaster and begin to stabilize our economy.

Some of the plans that have been proposed, including the plan I have devised, address the underlying problems that make the assets toxic. All of those plans, except mine, rely on a combination of lowering interest rates, extending the life of the loan, and requiring the forfeiture of some of the principal of the loan in order to lower mortgage payments to a certain level. These plans all suffer several deficiencies. First, interest rates must be lowered, once again, to artificially low levels. They may not be set as low as during the introductory period of the loan, but it establishes the same kind of latent problem from which all these toxic assets initially sprung. Even if those interest rates are increased by only 1% per year, the payments will soon rise to levels that again will seriously stress borrowers. Second, the extension of the life of a loan from 30 years to 60 years provides significant reductions only when the interest rate is about 3% or lower, but has very little effect when the interest rate is higher than 3%. Those plans would not even extend the life of the loan that far, though. They only propose extensions to 40 years, which would produce even less effect in lowering monthly payments. Finally, if the target monthly payments have not been achieved with the other two mechanisms, those plans advocate the forfeiture by banks or lenders some of the principal balance of the loan. The obvious problem here is that the banks are asked to take a loss on the mortgage without any compensation. Some may feel that this is justified because the banks engaged in reckless or predatory lending practices. However, the borrowers also share some of the blame for buying properties they could not really afford, but this approach gives them a partial free pass. In summary, these plans contain moral hazard problems (in forgiving parties for their bad behavior), and do little to actually detoxify the toxic assets. Indeed, studies have found that approximately half of all loans modified according to such plans re-default within one year.

The plan I have devised, however, truly detoxifies the toxic assets and also avoids the moral hazard problems. As opposed to the other plans, my plan focuses on modifying the principal balance of the loan because that is the most effective way to reduce the monthly mortgage payment. In addition, my plan does not require the banks or lenders to simply forfeit the principal that is reduced. Rather, that reduction in principal is treated as an investment by the banks – they get something in return for modifying the loan. This provides a crucial incentive to induce the banks to participate in the process. Just as importantly, though, is the fact that my plan does not try to fix the problem of default by creating another artificial situation just to ease the borrowers’ payments. Under my plan, the interest rates of loans remain at market rates and the lives of the loans remain unchanged. That means that the interest rate does not need to be “corrected” back to its market level later. This means that the borrowers will not face increasing pressure on their payments again, as in the other plans, due to interest rates being increased. My plan does not just postpone the problem; it addresses it.