Mortgages and Uncertainty

My understanding of the Obama-Geithner plan for restoring financial institutions is that it rests on a hope and a prayer: a hope that no more mortgages will go underwater, and a prayer that underwater mortgages will get paid back at something close to par.

FWIW, my view is this sort of dithering is similar to what the Japanese did in the 1990s, and what we did with the Savings and Loans through the 1980s. The argument is that the mortgages on bank balance sheets are worth more than their current market value, and that by basically forbearing, the financial system can wait out (sweat out?) the problem.

I fear that part of the problem is that Geithner doesn't have mortgage experts on his team. Many people who are brilliant at finance do not understand the behavioral aspects of mortgages (a year or so ago, Eugene Fama called mortgages uncomplicated). The problem is that mortgages have lots of embedded options, and that borrowers do not always exercise them ruthlessly. They exercise the call (prepayment) option when it is out of the money because they have to move. They fail to exercise the call option when it is in the money because they can't be bothered. They fail to exercise the put (default) options when it is in the money, because they care about their reputation for paying their bills, or because they don't know the real value of their house. They do exercise the put option when it is in the money because they lose their job, or they get sick, or they have marital difficulty. And the option can move in and out of the money with remarkable swiftness.

Modeling all of this is hard work, because financial models--such as those used to value callable corporates--are just not sufficient. If we set up something like a home owners loan corporation, we could recognize losses at their likely maximum, and keep mortgages current going forward. It seems to me that this would do the least harm and allow the financial system to reset.