How to Restore the Health & Stability of the Economy
Graciela Chichilnisky Columbia University New York, October 11, 2008 Contact phone: 212 678 1148 For a Video see:
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Graciela Chichilnisky is Professor at Columbia University in Mathematics and Economics. She is an expert in short sales and asset backed securities, financial innovation and widespread default, has created financial instruments known as ‘catastrophe bundles,’ and is the author of the carbon market of the Kyoto Protocol of the United Nations.
An extremely important fact has been absent from the analysis of the financial crisis, and is jeopardizing the opportunity to resolve it effectively. The astonishing scope and spread of the crisis is due to a snowballing effect that amplifies defaults on mortgages into 33 to 100 times the value of the assets at stake, magnifying and spreading them into default and bankruptcies across the entire world financial system. Therefore to resolve the financial crisis one has to stop the defaults on mortgages right now. These defaults are the true root cause of the larger financial crisis. This can be achieved by restructuring the monthly payments, decreasing them by 50%, or according to the Housing Price Index. The details matter. But in any case, this can make the mortgages more affordable and better aligned with lower property values.1 This works because homeowners can afford to continue paying the mortgages and makes it worth for them to do so. The banking system is stabilized because banks receive continued payments of 50 c on the dollar providing them with an infusion of capital, and reduced bank discount rates can be arranged to match and sustain banks’ balance sheets. This one – two punch can stem the wave of defaults and bankruptcies and stabilize the banking system. Furthermore, this plan works as a tax rebate: homeowners will have more money in their pockets thus stimulating the economy, increasing spending and creating jobs. With its recent $700 billion bailout the government is trying to deal with the effect and not with the cause. The true root cause of the financial crisis starts with the continued defaults on mortgages that magnify and snowball throughout the entire financial system due to a historic combination of financial innovation and deregulation.2
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The actual adjustment can be pegged to a Housing Price Index that varies from region to region, and the % of the home value that the mortgage represents. 2 Countrywide and its parent Bank of America have recently been sued successfully for predatory lending practices in 11 sates, and were made to restructure mortgages and loan aid amounting to $8 billion. The
This is how it works. Each mortgage became part of widely traded ‘mortgage backed securities.’ Freddie Mac and Fannie Mae fueled the process by buying about $5.2 trillion worth of mortgages from the banks, representing about 40% of US real estate assets of $12 trillion. On top of that, many financial institutions traded a large number of derivative securities such as interest rates swaps and options based on mortgage backed securities that can magnify gains and losses by a factor of 2 or 3. They were able to leverage their assets 33 to 1 due to deregulation. They borrowed, lent and traded 33 times more than the value of their assets. This way each mortgage default was magnified and snowballed into trades worth 33 to 100 times more than the original mortgages. The derivative market itself is now worth $530 trillion.3 The process is a money making machine when things go well – it hugely magnified gains as real estate prices went up. Equally, it hugely magnifies and snowballs losses on the way down. Today 9.15% of all mortgages are in default, about twice the historical standards 4 representing about $1 trillion in assets. Since each mortgage default snowballs into 33 to 100 times the initial value, this leads to widespread defaults and bankruptcies in financial institutions. The key to solving the problem is to stop the snowball when it is small and not after it grows huge and impossible to contain. The $700 billion bailout deals with the after effects, provides liquidity and buys out some mortgage backed securities, derivatives and mortgages. But it does not deal with the true root cause. Unless we stop the continued mortgage defaults the financial crisis will continue and will get worse: defaults, foreclosures, bankruptcies, unemployment and a painful economic contraction. In sum: restructure mortgages now, 50 cents on the dollar or appropriately adjusted according to the price index. Stop the continued defaults and offer discounted bank rates and the banking system will stabilize. This proposal requires minimal intervention from Congress,5 and minimal international cooperation in lowering bank rates to prevent currency swings.6 But it costs the tax payer virtually nothing and it helps restore the health of the economy. This proposal, or something close to it, is virtually the only thing that will work.
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process is proceeding successfully and is an example of what can be achieved if the problem is tackled systematically in this way. $8 billion is about 1% of the total value of the Federal bailout. 3 Source: International Swaps and Derivatives Association. This market was worth $106 trillion in 2002, see also New York Times, October 9 2008, p. A29. 4 Source: Mortgage Bankers Association, cf. New York Times, October 6 2008, p. B9. 5 Congress could authorize a flexible downward adjustment of fixed rates mortgage’s contracts . A 50% downward adjustment would do the job proposed here. 6 A unilateral decline in the bank discount rate by a nation could cause rapid swings in currency trading which is better avoided.
Selected publications by G. Chichilnisky on Asset Backed Securities, Short Sales, Financial Innovation Volatility and Widespread Default – see www.chichilnisky.com - Books and Writings.
83. "Competitive Equilibrium in Sobolev Spaces Without Bounds on Short Sales," (with Geoffrey Heal), Working Paper No. 79, Institute for Mathematics and its Applications, University of Minnesota, June 1984, Journal of Economic Theory, Vol. 59 No. 2, April 1993, p. 364-384.
112. G. Chichilnisky: "Option Values and Endogenous Uncertainty in MBO's ESOP's and Asset Backed Securities" (with G. Heal and D. Tsomocos), Economic Letters, 1995, Vol. 48, No. 3-4, p. 379-388. 122. G. Chichilnisky: "Financial Innovation in Property Catastrophe Reinsurance: The Convergence of Insurance and Capital Markets,," Risk Financing Newsletter, Vol. 13 No. 2, June 1996. 133. G.Chichilnisky: Volatility in the Knowledge Economy, (with O. Gorbachev), Economic Theory, Vol 24 No 3, September 2004. 134. G. Chichilnisky: "Volatility and Job Creation in the Knowledge Economy" (with O. Gorbachev) Essays in Dynamic General Equilibrium Theory Festschrift for David Cass. Series: Studies in Economic Theory, Vol. 20, (Eds. Citanna, A.; Donaldson, J.; Polemarchakis, H.; Siconolfi, P.; Spear, S.) 2005, p45-74. 140. G.Chichilnisky: "General Equilibrium with Endogenous Uncertainty and Default," with Ho-Mou Wu Journal of Mathematical Economics, 42, May 2006 142. "Catastrophic Risks: The Need for New Tools, Financial Instruments and Institutions," Privatization of Risk - Social Science Research Council, June 2006