Making the Bailout Work

The solution to our current financial system mess lies in recognizing the shift between equity and debt which the housing and mortgage market turmoil has created.   Merely buying loans from banks will NOT relieve the burden on homeowners nor will it force the discipline needed to fix the marking to market mess. The government should mandate that every mortgage loan being considered for purchase through the bailout mechanism be subject to an appraisal for the underlying property.  

If the appraisal suggests a loan to value ration in excess of 110%, it is time to recognize that a PORTION of the loan is in reality an equity investment.  All such loans which conform to present Fannie and Freddie standards should then be subjected to a mandatory split into two pieces one for 90% of the current appraised value and the other for the remainder.

The 90% of the appraised value piece could be safely given a Fannie/Freddie guarantee while the other piece could not. The first piece would have an established market value based on par for the principal and current interest rates. The second piece would be valued as if it were in effect participating equity.  Banks and borrowers should have the option of exchanging the second piece for up to 75% of the future appreciation in the property valuing each 25% of future appreciation (above the current  appraised value determined above) at 5% of the current appraised value of the home.  The second pieces could then be valued based on these ratios.

If the borrower agrees to this exchange, his debt would be reduced to the 90% of current appraised value level. If he does not, then the debt in excess of the 90% would remain outstanding.  No forbearance should be allowed to borrowers who refuse the exchange.

These two steps would restore value to perhaps 70-80% of the currently illiquid uncertain mortgage assets plaguing the US financial markets.    The mess would be over.

Guest article contributed by Michael Lissack.  For more information about the author please visit  http://www.lissack.com/