Vox's Bad Plan B

Luigi Zingales recently wrote an article criticizing Paulson's TARP package and proposing his own Plan B.

Paulson’s plan won’t work. Leaders agreed to inject equity into the banking system, but too little, too late. Nothing short of a 5% increase in banks’ equity capital (about $600 billion) will restore confidence. This column explains that even then, there are three additional problems. We need a plan that minimizes the bailout money so we’ll have some for a stimulus package to restart the economy. (continued)

Unfortunately, his plan won't work either and is filled with holes. As a property manager myself, renting out a property is harder than it sounds. Someone has to maintain the property and there's always something that needs to be repaired, like the garbage disposal or a leaking shower head. I don't think the government is capable of property management, they'd have to create yet another agency to rent out the properties. The costs would be very very high, which is why banks don't rent properties in foreclosure, it's cheaper for them to leave them empty and sell them at auction. Banks aren't in the property management businesses and are wise enough not to get into an area where they have no expertise, but will require a large amount of resources.

The plan is not very good, in the end someone has to take the losses, you can postpone those losses for a while, but all that accomplishes is long term stagnation like what is happening in Japan.

Debt holders usually get the residual assets in a bankrupt company anyway. I don't see how forcing bankruptcy on lots of financial institutions would benefit them or anyone else. Bond prices would collapse and fear would spread. Plus what would bond holders do with the toxic stuff once they gain control anyway? All you do is transfer the toxic mortgages to new owners, and if those assets decline in value, then the new stockholders will face the same problems and need to raise more equity. Maybe we'll have another round of bankruptcies.

The problem with subprime mortgages is not necessarily that they are underwater, it's that the current mortgage borrowers can't afford to pay the interest. If forgiving 30% of the principal isn't enough to reduce payments to levels that borrowers can afford, then it will do no good at all. The borrower will also do a calculation, is it worth it to keep on paying interest on the property and accept only 50% of gains AFTER the property rises to what he paid for it originally? Or would it be better to walk away, save money on interest (if renting is cheaper), and then buy into a new home at lower cost where he stands to capture 100% of gains from the lower price point?

The plan is not very well thought out. Hedge funds routinely close after losing 30%, even if they can make that money back, the managers know that they won't get the 20% standard fee on gains until they first make up for that 30%. It's much easier and profitable to close down the fund and open a new fund that will give them 20% without first having to get back that 30% they lost. The only barrier is the willingness of investors to put money into the new fund. This is almost exactly what underwater homeowners face. Why bother trying to make up for lost equity when you can walk away, wipe the slate clean, and then take 100% of gains from a new, lower price point? The only issue is if they can acquire a new property. In the end, Vox's Plan B is even worse than the bailout package on the table currently.