A Policy Response to the Credit Crunch

These are amazing times. Credit crunch, housing price collapses and people caring about credit default swap novation protocols. Meanwhile, all sorts of crazy proposals are making their way through Congress.

Conceptually, I like the idea of many of the low-cost solutions that are floating around. I just don’t think the low cost, low pain solutions will be sufficient in addressing the problem associated with I happen to believe that the high cost of stopping the bleeding represented by what we're witnessing will require everyone to pay. I have heard those who suggest that this is tantamount to the prudent paying for the profligate; they have valid complaints. I believe, however, that absent a solution, the prudent will pay in the form of protracted recession and RAPID asset devaluation across the spectrum. I think the long-term consequences of rapid and severe corrections won't

As a result, here's a proposal that I would propose, if less palatable from a (short-term) fiscal standpoint:

CHANGE THE MORTGAGE INTEREST DEDUCTION
1. Eliminate all deductions for mortgage interest not related to a PRIMARY RESIDENCE.
This is already going to be expensive to fix, and this seems like a reasonable place to draw the line. We can at least eliminate current and future subsidies for vacation homes, second homes and timeshares. I would also change the definition of qualifying mortgage interest to require that mortgages must be <80% LTV OR have private mortgage insurance at the time of purchase.

2. Establish a CAPPED TAX CREDIT for mortgage interest paid on a PRIMARY RESIDENCE.
The cap would be somewhat low, say $10,000, and it would be a dollar-for-dollar match against FIRST mortgage interest on a PRIMARY RESIDENCE. This would be a direct incentive for at lease some of the upside down homeowners to stay and fight to keep their homes.

3. Increase the size of the mortgage that can create deductible interest.
While a simple increase (e.g., from $1 million to $2 million) would likely work, it would be nice if it would be a function of FHA caps (e.g., 2.5 times the zip code's FHA cap). The current straight line formula has the effect of giving very wealthy/high income people a subsidy if they happen to live in an area that has a very low median home price. Using the FHA cap would serve to normalize this somewhat, while also shifting some dollars to the higher cost areas where the impacts are necessarily more severe. To minimize the potential for this spiraling out of control, a dollar cap could be placed on the total interest that could be deducted.

USE A FEDERAL AGENCY TO BUY DISCOUNTED MORTGAGES
This is also advocated by others. I agree that the market needs this support system in order to recover. However, I believe that the market participants do need some incentives to contribute to a solution. As a result, the agency protocols for purchasing paper would require that it be purchased at 85% or 90% of its outstanding amount, in effect, placing a floor on the loss on the mortgage pools. This would support the security holders, who could at least come to grips with potential losses that are more certain in (smaller) magnitude and -- because of the other measures -- with a lower degree of probability. It would, however, provide some incentive for note holders to make attempts to accommodate the homeowners and work to establish an alternative arrangement that is nonetheless higher than the 85% or 90% they'll receive from the agency.


INCREASE THE DEDUCTION FOR PROPERTY TAXES
This is in current proposals before Congress. Small, but it can't hurt.


PHASE OUT DEFERRED COMPENSATION TREATMENT FOR NON-401(K)/403(B) PLANS
The many high income earners who use these plans will be upset by this, but it feels like an appropriate place to get money without “increasing taxes”. In the end, it’s not all that likely that the deferral benefits them considerably (although tax-sheltered gains are pretty nice), since tax rates will likely be considerably higher in the future than they are today. To alleviate the inevitable disappointment, the liquidated monies could be taxed at special rates to at least give some benefit today to the deferral. But this is money that needs to be taxed today.



Frankly, there are some things I don't like about this proposal.

• I don't like further engineering a broken tax code, which this does. I don't like further entrenching the AMT, which this will necessarily require, since it will be even more expensive to "fix" it.
• I don't like that it will necessarily be viewed as a "bailout" of homeowners and security holders alike, creating a moral hazard that must be monitored closely.
• I don’t like the head-fake on deferred compensation.
• I am somewhat concerned that it ignores other areas of the market, like commercial real estate and municipal securities.

On balance, however, these negatives are relatively minor. I like the fact that it creates incentives for the various participants to get back in the game. Homeowners have incentive to stay in their homes and not "walk away". Security holders have incentive to re-engage and start participating in a meaningfully active market that allow us to relatively value these positions, rather than through a broad-based approach extrapolated from CDS indices. And I believe/hope that addressing the residential mortgages will help calm the commercial real estate and municipal securities markets.

It is interesting how strong some of the feelings are about this topic. Some wishing the worst for homeowners who, over the past five years, have lorded their success over those who had not become homeowners themselves. These "responsible" people at some level sense that their vindication is near; their vitriol seems to extend even to leverage employed at financial institutions. Unfortunately, the consequences of the rapid deleveraging that we are witnessing will consume us all. We cannot simply watch the fire over the hills; we have to put it out quickly before we are all burned.