(Dt. Wednesday, September 24, 2008)

Sub: The Completely Unnecessary $700-billion Market Intervention Plan That is Under Review in the United States Congress

I have been watching on television, some parts of the discussion in the United States Congress about the $700-billion market intervention plan proposed by the Government authorities, during the last two days. Many of the Senators, from both parties, seemed really well-informed and their questions were probing. In addition, Senator Charles Schumer was quite eloquent. He mentioned that he had been speaking with several well-known economists about the best way forward. I suppose the other senators have been consulting professional economists as well. So, it was surprising to me that the main topics of discussion were only about price-discovery, or liquidity in the markets, or injection of capital, or whether spending $150 billion now is enough, or how to cap Wall Street compensation, or how to throw in some help for the home-owners. Why didn't the economists advise the representatives of the United States Congress that this whole $700-billion market intervention plan is completely unnecessary, as explained below?

(1) Even by my crude estimate, there are at most 50 million homes across the United States whose mortgage loans are being currently traded as asset-backed securities. These mortgage loans, taken out by the home-owners, have been packaged into groups on which the mortgage securities have been issued. My guess, admittedly a rough estimate, is that each of these packaged-groups would contain anywhere from 1000 to 10,000 mortgage loans. This implies that the number of packaged-groups of mortgages in the United States would be between 5,000 to 50,000. This means that the whole information about the mortgaged homes and the securities issued against them in the United States can be processed in a single laptop personal computer! This further implies that the $700-billion market intervention plan proposed by the Government authorities and under review in United States Congress is completely unnecessary:

By directly matching the holders of a given mortgage security with the home-owners whose mortgage loans are collateral for that security, all the concerns expressed in the $700-billion market intervention plan can be addressed effectively. Because the home-owners and the security holders are more directly involved in the mortgage transaction than the Government is, the investment banks can compete with each other, and bargain with the home-owners, to facilitate price-discovery in the most optimal fashion. In particular, the Wall Street investment firms are facing the prospect of having to sell their holdings at fire-sale prices (something attested to by Professor Benjamin Bernanke in his Congresional Testimony yesterday). These same firms can, instead, devise mortgage pay-back agreements offering significant discounts to the home-owners, and still recover a much better price than the fire-sale levels they are facing now. Moreover, these discounts can be designed to reward good behavior on the home-owners' part. For example, if the home-owner had been paying his/her mortgage installments without fail, (s)he could be given a rebate. Further, (s)he could be promised that if (s)he continues to pay down her loan sincerely in the future as well, then rebate(s) would be given at the end of a year, at the end of five years, and so on.

This direct-matching plan would reduce foreclosures because the home-owners get a 'rebate' on their loan obligations. But these rebates are determined completely by market forces, and not by the intervention of the Government. Since the number of foreclosures are reduced, this keeps the market values of the homes from falling precipitously. Moreover, its costs very little for the Government. All that is needed from the Government is that it maintains and provides reliable information about each packaged-group of mortgaged homes and the securities issued against it. Also, since this direct-matching plan reduces uncertainty immediately -- much quicker than the $700-billion market intervention plan which would need elaborate auction arrangements -- the freezing up of the markets would ease quickly. Thus liquidity in the markets would emerge automatically, without any Herculian efforts by the government authorities and the Congress.

Lastly, it seems to me that those home-owners whose mortgage loans are clubbed together in a single packaged-group would share some common features, like geographical proximity or similar standard of living, or same time of entry into the housing market, etc. Strictly speaking, these details are not necessary for the direct-matching plan proposed above. But these details can be utilized to provide further effectiveness in the solution.

(2) It seems to be that any public discussion about the current financial crisis quickly moves into comparisons with the Great Depression of the late 1920s and the early 30s. Particularly, grave concerns are expressed about the freezing up of the markets due to break-down of trust. As a result, the mind-set of the participants simply focusses on macroscopic interventions by the Government or the Federal Reserve to intervene in some way or the other. In my opinion, though direct comparisons with the Great Depression are useful in some ways, it is a mistake to restrict the focus of the discussion solely on the Great Depression, or other previous financial crisis that have occured in earlier decades.

Sure, illiquidity in the markets is caused by break-down of trust and other psychological factors like fear and panic. However, a equally strong factor is the lack of real-world information about the securities that are being traded. In this single respect, the current financial crisis differs seriously with the Great Depression. The modern economy is much more information-based. Just by using a few laptops, credible and reliable information about who the other party in the transaction is, can be uncovered. This information helps to design the features of the transaction in such a way that liquidity is facilitated automatically. Please recall that I had been emphasizing that the direct gathering of mortgage information through econometric methods is important in my "Update 2: A Marginalistic Interpretation of the GARCH model" which I had sent out on Sunday, May 4, 2008. Thank you.

Sincerely,
T V Selvakumaran