Senior Fellow Walker Todd was a presenter at the 17th Annual Hyman P. Minsk Conference on the State of the U.S. and World Economies.   A summary of his presentation on how the State of Ohio could refinance mortgages follows:

WALKER F. TODD recommended that all bank officers and broker-dealers pass a history test about financial panics, including the works of Charles Mackay, Charles P. Kindleberger, and C. Lowell Harriss. He outlined his rescue plan—a single-purpose, stand-alone entity with a defined term limit—by which the state of Ohio could refinance mortgages in response to the current debacle of subprime mortgage lending. The history of the HOLC, created by the Loan Bank Act of 1932, emphasizes the importance of leadership and political institutions. Therefore, it is necessary to carefully select the person who would run the entity because it would be handing out public money for free.

Todd noted that when the financial crisis began, the Fed had $800 billion on its balance sheet, but it has already committed one-half of this amount to the primary-dealer community without public debate. Moreover, the Fed will keep increasing the amount at each new (28-day) auction cycle in response to ongoing requests by the dealers. As a result, there will be insufficient Fed funds to carry out proposals such as D’Arista’s new system of reserve management.

Todd suggested that conference participants introduce his plan, which was carefully crafted for conditions in the heartland, to the State of New York. He observed that the home mortgage foreclosure crisis could be divided into two areas: the Sunbelt states (California, Arizona,Nevada, and Florida) and the greater New York region, where there was a speculative bubble in housingprices; and the Great Lake states and cities in the Midwest (e.g., Cleveland and Detroit), where there was no bubble. Thus, the solution to the mortgage crisis will vary between the two areas.

The highest per capita foreclosure rates have occurred in the areas without a speculative housing bubble (especially in minority neighborhoods) because of a new breed of mortgage lenders. Refinancing reduced homeowners’ mortgage monthly payments, but when these payments were reset higher a few years later, in an environment of declining employment, the reset had devastating consequences for household finances. Todd noted that the refinancing options were advertised as “fixed-rate mortgage loans,” and the Fed allowed lenders to get away with this misinformation.

In Ohio, the state has proposed to finance the appointment of an attorney for every homeowner wishing to contest mortgage foreclosure of the homeowner’s property. Todd said he believed this approach was fruitless, because the banks would still be left holding the bag even if all the attorneys won their cases. A successful plan needs to provide relief to both homeowners and financial institutions. History suggests that the most effective approach is to implement a state-level restructuring of mortgage loans patterned after the RFC.

According to Todd, states can and should act on their own in confronting the mortgage debacle. His plan includes creating an entity or board and issuing bonds for the principal amount of mortgages to be refinanced. State financing would place a cap on the rate and concentration of foreclosures, and a floor under housing prices. The entity should be ready to purchase all mortgages within certain parameters at a purchase price that the lenders and investors advanced or paid (taking into account accrued interest already received). No homeowner should be charged interest greater than the initial rate for floating-rate mortgage loans or more than 3 percent above the Treasury’s five-year note rate on the date of issuance of the mortgage for fixed-rate loans. Homeowners would be expected to stay current on their mortgages at the new rate, and the state’s potential liability could be capped.

Essentially, the state entity would pay out higher-rate obligations and receive lower-rate income streams. Losses would be recovered through the state’s taking out a lien on the covered real estate equal to the expected final value of the payment differential for each mortgage. Borrowers, Todd said, should be encouraged to seek private sector refinancing for conventional fixed-rate mortgages after 10 years in the program. He also outlined how the state entity could respond when a depository institution tendered its mortgage portfolio.

In essence, the state would fund the program by borrowing money under tax-exempt bond issues, an action that has the support of the Treasury and the White House. A plan by Congress to impose a penalty on the face value of the loans is unconstitutional (i.e., taking private property for public use), so the state would have to offer par values to the lenders less any accrued interest paid since the inception of the loan. Pollock has stated in public that he would want warrants on the common stock of the banks that get bailed out. By contrast, the financial establishment wants the Federal Reserve balance sheet transferred into its corporate coffers without any executive compensation or effect on stock values.

Todd recommended that the state maintain the principles and qualifying standards of the Hope Now program and facilitate financing for those who qualify, with a cap of, say, 10 percent of the equity value of the home and the chance to refinance for 10 years at a fixed rate that is subsidized by the state. By adding 1 percent of net equity per year, the homeowner would have 10 percent equity after 10 years, and could then go to the Federal Housing Administration for refinancing. Nontax revenues would be needed to fund this program, but in states such as Ohio, all of these revenues have been directed toward an economic stimulus package that includes a host of pork projects that will do nothing in the long run.

Since a targeted mortgage relief package places a floor under falling house prices, it would mean the beginning of recovery. And since the housing crisis is the root of all our problems, Todd said, it should be addressed first. He cautioned that attempts to address the housing problem at the national level would be met by the standard Washington/Greenspan/economist arguments that bubbles either don’t exist or are impossible to identify. The response to such sophistry is to adopt the following rule of thumb: “If it is expanding by more than 25 percent a year in a low inflation environment, then you should assume that it is a bubble.”