Take a look at Krugman’s 4 step description of the crisis. Krugman says Paulson is trying to contain the mess at step 4 (using $700 billion over 2 years), while a better approach (Krugman’s) would be to act on step 2.
I can beat them both. I think a sensible rescue plan should work on step 1. That will make it more effective, equitable, and inexpensive.
According to a 2007 study by the Chicago Fed authored by S. Agarwal and C.T. Ho, the estimated face value of outstanding subprime loans in 2007 was $1.5 trillion. (I’ve seen other estimates at around $1.3 trillion, but let’s not quibble with details.) According to some sources, recent subprime delinquency rates nationally average 24% or so. The Mortgage Bankers Association estimates 19% subprime delinquency in its latest survey (thanks Doug Henwood and raghu for the leads) while the Chicago Fed study puts the rate at 15%, but let’s assume 25% delinquency. The exposed portion of those outstanding subprime mortgages amounts to $375 billion. The number of households involved is 2.5 million, under the assumption that the national average price of a subprime housing unit is $150,000.
If these calculations are even roughly accurate, the Treasury could — not buy those assets from the financial firms that hold them, directly or as underlying of derivative assets, but — locate the original issuers of the mortgages (the subprime borrowers) and help them make the monthly payments for the next 10 years. In 10 years, the borrowers will have enough equity to fend for themselves. And if the subprime borrowers are expected to service their loans normally over the next 10 years, then the financial firms that acquired securities backed by those mortgages will have capital to function, service their own liabilities, continue to provide credit to the economy, and overall perform the wonderful things they are known to always do for our social good.
Note that the Treasury doesn’t need to come up with $375 billion cash upfront. They just need to service a relatively small annuity with a total payment adding up to whatever is required to help those borrowers meet their payments on time over the next 10 years. Clearly, the present value of that annuity would be much less than $375 billion. If we say it’s $100 billion, we’d very likely be exaggerating. But let’s exaggerate and say it’s so.
Still, should the Treasury give away $100 billion to 2.5 million poor families who dared dream own a house? I am not going to make the “populist” argument that doing so is better than handing $700 billion to a few hundreds of shareholders and creditors of broke financial firms over 2 years (I’m sure that the $700 billion would not be the end of the Paulson plan, just like Wolfowitz’s $60 billion budget estimate wasn’t the total cost of the Iraq war). Giving money to people in need, of course, creates horrible moral hazard, which in turn erodes the basis of our civilization. When in distress caused by a disaster not of their making, people would grow accustomed to receiving the solidarity and support of the rest of society and, thus, would start to behave in self-destructive ways. As we know, only the rich have the moral fortitude to properly use government subsidies: the bigger the subsidies, the more morally they behave. So, no. There would be a quid pro quo, an upside to taxpayers.
Clearly, our economy and fisc underproduce key public goods and — as a result — the quality of our life suffers. Two of those goods are public education and public health. Clearly, if more Americans are educated and healthy, the rest of us benefit greatly. They would be more likely to be better coworkers, neighbors, citizens, etc. It turns out that, by helping those people the government would have tremendous leverage over them. Thus, the government could condition the financial help on their committing to sending their children to schools (all the way to college), and to schedule regular visits to the dentist and the physician. They themselves would commit to attending vocational school, if of age. Etc. That would make our society much more livable at their expense.
But, how would those schools and clinics be funded? They may not even exist. Let’s see. Say that the present value of locating the borrowers and managing the annuity fund to help them service their loans over the next 10 years is $20 billion. Again, I’m exaggerating. Now add that to the present value of the annuity, $100 billion. That’s $120 billion altogether. Take the first year of the Paulson plan: $350 billion. Subtract those $120 billion from them. You have a remainder of $180 billion. That’d be more than enough to build and fund those schools and clinics. How do I know? Based on the estimated present value of my family dental and medical plan (Oxford, using a discount rate of 5% p.a. and deeming these plans perpetuities, i.e. making premium payments not only over a lifetime but forever, as any decent government would do) , I estimate that giving good dental and medical care to 2.5 million people and their families would require less than $75 billion (present value). That’s health care. Education could use up the rest. Luckily, $120 billion would even leave change to cover with medical and dental services other segments of the currently uninsured population.
With about half the money Paulson wants us to give him, we can get the financial system back in shape and generate a substantial amount of public good at the expense of those reckless subprime people who started it all.
You are welcome.