Perhaps the best way of introducing this column is by briefly describing what popular capitalism is and applying it to a relevant topic of the day, specifically the mortgage crisis. This choice of application was made based not only on the widening scope of what is fast becoming a calamity of epic proportions through the obstinate folly of our leaders in pursuing and escalating a failed policy, but also from my personal experience in the field. Around the turn of the millenium, I was an application developer in mortgage and financial software, for which I utilized not only my programming skills, but my education and experience as an economist. Let us start, though, with the theoretical basis of this article and the column.
“Popular Capitalism”, as I have been using the term since the early 1980’s, is a political-economic philosophy which seeks to achieve the central goal of populism through capitalism. That central goal is power for all of the people, individually and without exception. To paraphrase Huey Long, populists seek to make the people kings and queens within the confines of their own castle. In my book, “Popular Capitalism”, this is achieved through applying the principles of classical economics to all institutions that affect or direct the transference of power within a community. The reason for taking a classical approach is not because I believe it predicts economic outcomes, but because it establishes a basis for the equitable allocation of costs and benefits which, in turn, discourages decisions that are damaging and encourages decisions which are helpful.It is a matter of laying down a fair set of rules for a game so that the players can feel that the game is worthwhile. If this is not done, then the unfairly treated players will, in one way or another, take their ball away and go home. One of the major conclusions of my book is that the critical point of fairness is that government should pay the costs of sovereignty and that those costs are the provision of survival value. Further, that provision should not distort the incentives and disincentives of the markets, and therefore their potential efficiency, as this would make the accumulation of independent wealth by the poorest of the people more difficult and less likely. Therefore, neither popular capitalism nor populism in general is egalitarian. Beyond the individual castles, power is and should be given to those who make the best use of it and thereby enhance the lives, wellbeing and power of their neighbors. In place of equality, Popular Capitalism offers freedom, independence and fairness. Popular Capitalism wants the people, even the weakest, to be free, alive and able to work where they can be most productive, being fairly rewarded for their success and fairly bearing the cost of their failures.
It is with this same sense of fairness that I have approached today’s great scourge: the mortgage crisis. Note that I do mean the same sense of fairness, a complete sense of fairness which encompasses the good times as well as the bad. I have heard far too much self-righteousness lately where powerless scapegoats are to be exiled to the nether regions as if that will fix any of the fundamental structural problems which are bedeviling us. Such talk disgusts and dismays me; it only sets us against each other when we need to help support each other. I have also heard more nonsense than I care to about CMOs, to which I will only say that the problem there was the introduction of credit default swaps. All of these avenues for recrimination and blame are mere icing on the cake. The root of the mortgage crisis is a sacred cow of such socially unimpeachable stature that I will surely be crucified for uttering such blasphemy. The root of the problem is the conventional mortgage itself.
Now I have said it. Before you prepare my crown of thorns, though, I would have you consider who reaps the rewards and who bears the loss from the all-blessed mortgage and whether that arrangement is at all fair. The buyer advances perhaps twenty percent of the purchase price of a home, with the lender fronting the remaining eighty percent. Though the lender in this all so conservative version of mortgage lending will verify the income of the borrower and new resident, that income is not the basis of the loan. The basis is the collateral which is the market value of the home. If the borrower takes a pay cut or loses their job, the lender will not go after the employer or former employer for the remaining principal. The lender will instead wait for the borrower to default, at which point the lender will foreclose and sell the foreclosed property for what he can.This shows clearly that a mortgage, being a loan based on collateral is, in reality, not a loan at all but an equity transference instrument.
Let us examine then the benefits and costs to borrower and lender of increased and decreased home prices relative to the initial purchase price. If the price of the home goes up $100K after ten years when it is sold, the borrower realizes a profit of $100K even though his average equity stake might be around 40%. We can consider the interest to be his non-equity share of the rental charge of using the property as a dwelling.The remaining principal allows him to stay in his dwelling, so the interest compensates the lender for not being able to use that principal value. However, the lender receives nothing for the increase in the home’s value, even though his equity stake has averaged 60%.
Conversely, when the house prices go down by $100K, the borrower takes the whole $100K loss and the lender none under certain circumstances. What are the circumstances? If the lower price exceeds the remaining principal, then the borrower can still lose money by walking away. However, if the lower price fails to meet the remaining principal, particularly by a significant amount, then the borrower will save money by defaulting and abandoning the home. If the loss in insurmountable, the borrower may have no other choice.When this happens, the lender bears 100% of the loss. This introduces a bias in the contract towards the borrower.
The process by which the borrower’s gain or loss is magnified is called “leveraging”, which is a euphemism for speculating with other people’s money. The bias we have just seen in favor of the speculator and against the “other people” is an inherent feature of leveraged contracts like mortgages. This bias encourages more speculating with other people’s money, applying it to the market for the collateral product, in this case real estate. This produces a bias towards increased home prices. This, in turn, reduces the probability that the lender loss case will occur over the near term. Borrowers are virtually assured that there will be lenders as the speculative bubble starts expanding. Riskier borrowers are then preferred by lenders because their greater probability of default allows lenders to gain a windfall profit during a foreclosure: the profit they would have to forego with more creditworthy borrowers. Prices escalate and an expectation for further increases becomes entrenched. Even responsible borrowers who come late into an inflated real estate market and job market take the exorbitant housing prices to be the norm, buying houses based on an unsustainable income. It is when reliance on housing and job inflation is at its peak that the real estate and job markets are at their most vulnerable. The slightest softening results in lost jobs and then foreclosed homes which leaves other homeowners more vulnerable when the loss of neighbors and their expenditures leads to more job losses andso on as the bubble bursts. This devolution of the local economies puts more and more of the cautious homeowners at risk as once thriving communities more and more resemble ghost towns.
There is, however, a way out of this dismal scenario, and it involves replacing the disastrously leveraged conventional mortgage with a non-leveraged equity percentage transference instrument, the Adjustable Equity Mortgage or AEM. The AEM eliminates leveraging by tying the remaining principal and the monthly payment to the current market value of the home. In our previous example, as the home price increased, the lender would receive a larger coupon payment and when the borrower sold the property with, say, 50% equity, the lender and he would evenly split the profit with $50K each. Conversely, the loss would be evenly split and there would be no case where the borrower would have negative equity that might induce him to abandon the house or saddle the lender with a loss. Even if housing inflation occurs for other reasons, there is no benefit for a lender to take on a risky borrower. The factors by which the conventional mortgage produces speculative bubbles simply do not apply to AEMs.
Moreover, conversion of conventional mortgages, even of recent foreclosed properties, into AEMs rehabilitates those contracts. By adjusting the remaining principal and coupon payments – by multiplying the current values by the current market value divided by the initial market value – the resulting instrument is more sustainable as borrowers can make payments with the lower paying jobs now available in their region and both borrower and lender can avoid turning a paper loss into a real one. Where the AEM has to be terminated, it can be done gracefully and without prejudice, with the borrower receiving his percentage share of the equity and applying it towards a down payment in a cheaper housing market. Thus, collapse in the real estate market is replaced by shifting and realignment.
Since this is a solution by means of contract law, its administration lies naturally in the courts. Thus I suggest the founding of a judicial bank, preferably at the federal level with state branches. If the federal government is not forthcoming, New Jersey will have to form its own judicial bank to administer AEMs and other non-leveraged and approved contracts. Whatever the level, the costs of this solution are minimal administrative ones, obviating the massive public spending and borrowing that are destroying our economy.