The Invisible Hand of Foreclosure Prevention

“These are complicated instruments” they say. We have thousands of bits of mortgages spread over billion dollar pools known as CDOs. Trying to value, or more importantly reconstruct, a mortgage is like trying to build a sandcastle in a hurricane. Let’s accept the premise that the current system is broken beyond repair - and move forwards. While Congress was busy grandstanding, I was trying to figure out a solution.
When a company needs money to purchase assets, it can go to the bond market and issue debt. This debt trades at some value and can usually be bought back below par. Imagine a company issues $50MM at par, and the very next day, a black swan visits Wall Street causing a crash. On this day, the bonds start trading at 80 cents on the dollar. Barring some debt indentures, this company can now repurchase its own $50MM of debt for only $40MM. When the home owner needs money to purchase assets, he or she goes to the lender. Regardless of the economic situation, the home owner is always asked to pay back his debt at par plus accrued interest. There is no reason this practice should continue.
Merrill Lynch sold its mortgage debt portfolio for 22 cents on the dollar. I can imagine almost every single home owner will to pay 23, or more, cents on the dollar for their own mortgage, or for that tranche of their mortgage.
Mortgages should be traded on an exchange where home owners can buy securities that they can later tender in for their mortgage. If we had this system, there would be no issues with transparency, no guessing of values, and stabilize foreclosure rates due to mortgages being under water.
We can use parts of the options trading model to help do this. Each mortgage type will trade within its own category. The following list is not exhaustive but should help clarify my plan.
• By Length of Mortgage (10,15,30 year)
• By Type (Fixed vs. Arm)
• By interest rate ( 5.75%, 5.875%, 6.00%, etc…)
• By FICO Score of Borrower (In 10 point Increments)
• By Geographic region (Midwest vs. Northeast – or maybe even more specific)
• Conforming vs. Jumbo
It would be hard to argue that one 30 year, 5.00% fixed conforming mortgage from a Midwest borrower with an 800 FICO score should be valued different from another. Therefore, if today such a mortgage was trading at 95 cents on the dollar, the individual who was responsible can be rewarded. At the same time, California sub-prime home owner would a choice between foreclosure and trying to repurchase their mortgage below Face Value, preventing mass foreclosures. Lenders could write in specifics to which securities they will allow as tender for the mortgage to protect themselves.
The current system is broken and should not be continued in the future. Let’s replace it with a transparent system that will allow the market to price the value of this debt, like it does so with corporate debt.