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Friday, July 16, 2010

Real Estate Mortgage problem and deflation

Barry Ritholtz links to a post by Dhaval Joshi, chief strategist at RAB Capital about size of the housing mortgage debt problem. Dhaval Joshi quantifies the size of the problem. He believes the value has to drop by about $4 Trillion to revert to mean values. This is approximately 27% of annual US GDP. This size of deflation has repercussions.

In whose hands assets deflate matters
Typically, asset price increases happens at the hands of the rich. (The causality is inverse - asset price increases result in wealth.) However, where does the asset price decrease happen? The answer to this question determines the power of the corresponding economic slowdown. 

When housing asset prices declines, the asset is usually at the hands of common person and the downside impact of price decline hits the common person's financials. In that context, the current crisis was safer (we may say most crises are). In this crisis, we can argue, a dotted line ownership of the assets, through MBS and related derivatives, was in the hands of the financial institution. The devaluation of assets, thus, was happening at the hands of the rich. (It was also happening at the hands of the poor is incidental for what I am saying).

I contend that bailouts are causing a change of hands. Through bailouts, the burden was passed from financial institutions to the tax payer who is the common person. I think the bailout may have doubled the burden on the US tax payer. Can we say, US tax payer will effectively bear a burden of nearly $6 trillion?

In this context my public bank proposal seems more effective
If the government had set up a public bank to buy back mortgages from current banks, we may have avoided twin problem. I had proposed that the bailout money be used to create a public bank that will buy existing mortgages from the home-owners allowing them to reduce their debt while pushing money in proportion to asset quality. This solution appears more favorable to me now. First, the large burden of bailout would not rest on tax payers. It would have gone to other investors when the bank is finally privatized. Second, it would put a bottom on the home prices and thus not allow household financial to deteriorate drastically.

Given the options on the table, even now this looks better.