There has been much talk about restoring the original TARP plan to the acquisition of toxic assets from the banks. We don’t think it will work to restore the system. Here’s our thinking.

1. The so-called toxic assets are not necessarily toxic; some, indeed many are performing well.
2. Buying those assets will cost more than $1.2 Trillion
3. The purchase will not recapitalize the banks in the long-term, but only in the short term because the banks will continue making bad loans and investors will not return to securitize lending backed paper.
4. The process will take up to two years as the assets will require individual, not desk-top appraisal.

If one considers these factors, toxic asset acquisition doesn’t work very well, compared to capital injection, as proposed by The Institute on September 28th, 2008.

Any bookkeeper or accountant will explain that a bank uses standard two-column bookkeeping, where they have Assets vs. Liabilities. The purpose of Capital Injection was simply to create an asset to offset the liability. If a bank has $5 Million in toxic assets on its books, they shift to the liability column. To offset those, Treasury may have invested $5 Million in capital. That should offset the liability. Even if the bank received only $2.5 Million and lends it to qualified borrowers at 10:1, the bank should have $25 Million in sound assets on its books, fully offsetting any remaining toxic assets or liabilities.

The capital injection program is working. Credit is easing, however, banks are stuck in a conundrum. How can they make loans if the public is not seeking them, fearful of getting themselves into trouble moving forward.

Public sentiment is to wait for large purchases, reflected clearly in the Consumer Durable Goods figures that have been consistently down, along with Consumer Sentiment surveys that show an unwillingness to spend, or use credit at the moment.

Media coverage discussing the deleveraging of property is creating fear in the marketplace to the point that any possible homeowner has to question whether buying a home today will be a prudent investment as the home’s value might decline for a substantial period before it recovers. It seems to most investors that waiting is best.

A Better Solution

If there’s going to be a further capital injection that offsets toxic assets the way to do it is by government creating a National Home Bank, funded with up to $1.5 Trillion. This bank would provide homeowners with second mortgages of 50% of the principal on existing mortgages up to $250,000, whichever is the lesser. Borrowers would not directly receive the funds. Rather, the National Home Bank would pay down the principal on the existing home provided the first bank agrees to reduce the rate on the first loan to a fixed  5.25% fixed rate and take the second position where the National Home Bank provides funding at rates between 2.5% and 5% on the loan they’re making. Borrowers would be required to pay for a new on-site appraisal, and must be no more than 60 days in default. Credit scores should be ignored in this case.

If the National Home Bank has to foreclose, they offer the borrower the option of a deed in lieu of foreclosure, and pays the original lender up to 50% of the remaining balance of the principal outstanding at the time of the default.

In this way, taxpayers own solid, performing assets, as opposed to toxic assets. Moreover, the National Home Bank, produces a profit for taxpayers in the form of interest income. For the banks, getting 50% of the principal on mortgages paid off is a good thing and should inject billions in capital into every bank, permitting them to lend again.

It also keeps people in their homes and restores the system of property valuations, without continual deleveraging of property values.

The National Home Bank would not make first mortgages on home purchases. Borrowers would have to use a traditional bank. Only borrowers who have risk of default could use the NHB. No equity lines of credit would be issued, nor would commercial loans or lines of credit or credit cards.

By taking this step, the entire home lending crisis could be ended in less than 12 months.

This will not resolve, however, the entire economic depression the nation, and indeed the world face today. Unemployment remains high and rising, creating further difficulty for the public to pay their bills or make important purchases such as cars or durable goods.

We believe that the proposed stimulus package should include better provisions for those who do not own homes but have extensive credit card debt. One suggestion made by a senior Congressional aide was to provide such individuals with an opportunity to receive funding to offset credit card debt without bankruptcy by up to 50%, provided the credit card companies will agree to reduce the principal by 50%. Thus, if a credit card borrower has $10,000 outstanding, and the creditor agrees to lower the principal to $5,000, the government could fund $2,500, payable to the credit card company, leaving the borrower with $2,500 in outstanding balances. These would be converted to a loan, payable over 10 years, but the borrower must agree to give up their credit cards for a minimum of 5 years before being requalified to obtain a credit card or line of credit.

The reason for this drastic step is to prevent additional bankruptcies, permitting the individual to rebuild their credit over time without the stigma associated with the bankruptcy process. It’s important to note here that we wrote some time ago about the adverse impact of credit reporting on the recovery of individuals over a 7 to 10 year period. The bankruptcy laws did not foresee that employers and insurers would use credit reports as they do. We continue to be concerned that credit reporting will prevent millions from getting health, auto, life or other insurance at reasonable, competitive rates, and harm the chances of these people from obtaining employment, even if the job applicant is eminently qualified for the position.

Insuring that the American public can recover from this crisis must be the first obligation of government as the lack of such individual recovery will result in the default of the whole, not the individual. What is good for the one is best for the many.