Tackling the mortgage crisis: a real alternative is possible

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I am disappointed to note that, as the FT reports:

There is no quick fix for Britain's mortgage crisis and the long-term funding of mortgages should be left to the market, a report to Alistair Darling will conclude on Tuesday.

The interim report from Sir James Crosby, the former HBOS chairman asked by the Treasury to lead a review into improving wholesale mortgage financing in April, is likely to receive a cool response from lenders who have been lobbying the government for rapid action to break the logjam in the mortgage market.

The Crosby report will also say that Britain should avoid US-style government-backed agencies to tackle the funding crisis.

I am profoundly disappointed by this. Such an approach is indicative of callous indifference to the plight of a great many people inside the United Kingdom whom it is obvious that Sir James would wish to carry the burden of obligation for the problems that banks have created. To believe that the market can provide a solution for a problem which the market so obviously created is not just na?Øve, it flies in the face of all evidence from history, and is indicative of a belief in dogma over practical reality. I sincerely hope that Sir James' report is dismissed out of hand as a consequence.

But let me also take this as an opportunity to present an alternative, because I am extraordinarily worried about the current state of the housing market in the UK and the consequences of that for ordinary people, which I rate an issue of considerably greater significance than the preservation of the free market.

I do think that there is a need for strong and positive government intervention in the housing market at present. All the evidence is that the credit crunch will continue for some time to come. If that is true then the policy that Sir James proposes is reckless in the extreme. Banks will face continued stress but will be unable to raise additional capital to strengthen their balance sheets simply because that capital will not exist elsewhere. Failures will follow. More mortgage foreclosures will result. House prices will fall further. Social turmoil will increase and the opportunity for Keynesian intervention without substantial inflationary pressure will also reduce because the capacity for further government borrowing will be limited. Economic recession is guaranteed as a result.

This makes clear that an alternative proposal is essential to stabilise the housing market, to prevent the social disruption arising from forcing people from their homes, to stabilise banks and to provide a new structure for use in the future that prevents recurrence of the problem and a deepening recession. In that case I offer the following as a possible solution for those banks and individuals faced with the risk of mortgage foreclosure.

First, when any bank reaches the point where foreclosure appears necessary the homeowner will automatically be offered a price by the government for the property on which foreclosure is to take place. The bank would have to accept this unless it could guarantee to better it. That price would be calculated in accordance with a formula.

The basic price to be offered would be determined by the market price for the property in August 2007 less an indexed reduction calculated on a regional basis, with that index updated quarterly (to prevent the creation of too intense a feedback cycle). So, for example, if the market price in August 2007 (when prices could be determined in a liquid environment) was £200,000 and the regional fall in value in the meantime was 10% then the basic offer price at the time foreclosure was threatened would be £180,000.

This basic offer price would not, however, be the sum paid. The price paid would depend upon whether the basic offer price would, if paid, clear the whole mortgage on the property, or not. If it would not clear the whole mortgage it is clear that home owner has lost all their equity in the property. If they are to remain in occupation of it (assuming they can afford the payments noted below) then they will do so as tenant, not as owner. In that case the government will acquire full title to the property upon redemption of the bank's mortgage. That redemption would, in this case, be paid at the basic offer price less a further 50% of the fall in value since August 2007. If the 50% increase was less than 10% of the mortgage value then that sum would be deducted instead to create comparability with the situation where there was residual equity in the property, noted below. This additional effective charge to the bank would be compensation to the government for three things. The first is saving the bank the cost of foreclosing and having to sell the property. The second is for providing the bank with a viable income stream sooner than it could have done if it had relied on a market solution for sale. The third is to compensate the government for the tax relief that will be given upon the mortgage loss to the bank and from which it should not secure a double benefit.

So, to extend the example noted above, in this case the bank would either be offered £170,000 as a redemption price for the mortgage and the government would in exchange secure full title to the property, to which the owner could not object (£170,000 being calculated as the basic offer price of £180,000 less 50% of the £20,000 fall in value since August 2007) or alternatively, if the mortgage was for £210,000 (and this is plausible) then the bank would be paid £180,000 less 10% of the value of the mortgage, or £159,000. It is stressed, the bank would not have the choice either of the price paid or whether to take part in the scheme or not. If the tenant were to ask that the scheme apply then it would (subject to evidence that they were not deliberately defaulting).

In practice, the government would not actually pay anything to the bank for redeeming the mortgage. The bank would instead be required to lend the funds previously advanced against the security of the property to the government and would in exchange be paid at an officially set rate of mortgage interest, which would be a balanced index of prevailing mortgage interest rates, less a discount for the value of the government guarantee. Average gilt rate would be paid, if lower. The advantage to the bank is, however, obvious. It has swapped a non-performing asset for a government backed security. Its balance sheet has immediately been straightened and its income stream secured.

If instead of the above the current formula calculated value of the property would allow, in principle, a full mortgage redemption because of the equity the owner had in the property then the bank must, if it has really reached the stage where foreclosure is necessary, have this consideration recognised but once again only through substitution of a loan to the government at the interest rate noted above for the original mortgage. In this case though to allow for the fact that there would, inevitably, have been a cost to the bank if it had been forced to foreclose a consideration of 10% of the mortgage value would be deducted from the redeemed loan to allow for those costs. To continue with the example already noted, and assuming the mortgage were for £140,000 the nominal mortgage redemption to be paid would be the mortgage value of £140,000 less 10% of that sum i.e. £126,000. In exchange for redeeming this sum (albeit, as above, by simply guaranteeing payment of the sum in question to the mortgage lender) the government would become co-owner of the property with the former sole owner.

But of course in this case the former sole owner still has equity in this property. £126,000 has been paid to redeem the mortgage on a property notionally worth £180,000 in the market place on which there had been a mortgage of £140,000. This equity now has to be split fairly, taking into consideration fairness for the taxpayer at large who has now helped secure the former sole owner's right to stay in this property as well as fairness for that former sole owner.

My suggestion is simple: the former sole owner had accepted liability for £140,000 of mortgage. They must continue to do so. The government will therefore have equity of £140,000 in the property, the former sole owner has equity of £40,000. But that is not the end of the issue. The former sole owner has a duty to pay for being allowed to stay in their property. That must be done in three ways. The first way is to ensure that they pay the government what will now be rent for the stake in the property that the government now owns. Since it was almost certainly the case that they could afford their former mortgage at some point during their ownership, probably because lower rate mortgage deals were available in the past, their capacity to make appropriate payments probably still exists. They should therefore be required to pay either the last fixed rate they had enjoyed on the property (so long as they had paid it for at least a year before foreclosure became an issue) or 1% above the government set mortgage rate to be paid to their former lender, if higher. If base rates fall the fixed price rate should fall by 90% of any cut in bank base rate. In this way the government should be able to service the debt assumed which will be 10% less than that which the now joint owner will, in any event, be servicing, so adding another margin for the sake of security.

Two additional protections should be available for the government. First, all falls in value should be charged against the equity stake of the original sole owner so that if they wish to leave the property and it is sold they bear in full the cost of sale and any fall in value until their equity is fully utilised. This would have been the case with a mortgage as well. Second, any increase in value should be shared equally between the government and the co-owner. This should compensate for any situations where the government suffers an absolute loss on sale of properties.

Do the economics of this stack? Well, I'm not promising every suggested percentage is correct. Clearly those would need to be worked through in detail, but they feel about right to me. But what we have got here is a situation where if a mortgage is to default a bank does not have to foreclose and force a person from their home, or dump a property on the market, so depressing prices further. The downward spiral of house prices is therefore broken. The owners are not forced into social housing. They can even keep an equity stake in some cases, and have an affordable mortgage in most cases. If it is not affordable on the formula shown then orderly rehousing to a property they can afford will be necessary, and enforceable. Given that the government will, inevitably, increase its social housing stock using this scheme the likelihood of such rehousing is much increased under this scheme. .

Former sole owners are protected under this scheme in that they can still live in their properties at what is likely to be reduced current cost , but will pay a long term cost for what has happened. That is appropriate.

Banks have their balance sheets effectively underpinned, and their losses limited. That stops the spiralling descents in the valuations we have seen.

No new money is required to make this work: existing mortgages are recycled into the arrangement. I admit that appeals to me, a lot.

There is a cash margin in the scheme for the government to cover its risk and cost of letting, and equity stakes are provided to it to cover market risks and risks of default and damage from former sole owners. Again, that is necessary insurance.

None of this happens unless foreclosure is the only real option for going forward, and it has sufficient cost for all parties to not make it an option of choice.

A deepening recession may be avoided though as a result.

So why not do it? It's hard to imagine why not. Unless of course you're Sir James Crosby and you seek to avoid government intervention in a bank made crisis at any cost, however big the social and economic disruption that might result from your failure to act.

Any comments and suggestions would be appreciated.