This should be our model in solving the debacle caused by the meltdown of the securitized mortgage market, and their derivatives.  The problem has many dimensions, but it can be categorized into a real financial problem, where homeowner mortgages are overvalued because the underlying collateral has depreciated, and a virtual financial problem, where these mortgages were bundled and "trunched" into complex derivatives, where the problem lies in assigning a value to a virtual asset. 

Virtual Derivatives.

Treasury Secretary Paulson is correct in stating that the meltdown we are experiencing in the now defunct derivatives market is one of "price discovery".  Derivative contracts and mortgage backed securities were bought and sold in unregulated investment "banks", under the assumption that the underlying value of the real estate nominals would always increase, never decrease. 

What we need to do now is to impose a similar legal ruling, by declaring that the underlying nominal valuation of these instruments, the real estate mortgages, are fixed to a value that is positive, that they "flat lined" their valuation at date of the derivative contract origination so that all such derivative contracts, and their swaps, trunches, etc can be closed at their original mark to maturity value. 

Since all participants in the derivatives market must abide by this ruling, the derivatives problem will be solved overnight, without a single taxpayer dollar from the Treasury. After all, these contracts were between financial entities, they must abide by the original contract assumptions, not circumstances unforeseen by both parties.

Derivative contracts are based on mathematical formulas, they are functions on the underlying nominal value, in this case, real estate mortgages. Since the value of these contracts is independent of the actual value of the real estate, because the parties to the contract do not actually own the nominal, their value can be assigned by law without any moral peril. 

Investment banks were in fact derivative trading houses, similar to stock market brokers, where the contracts were recorded between the parties, the investment banks were not a party to  these contracts.  If these contracts are "flat lined" by law, not allowing negative nominal valuations, they can be held to maturity at a known price.  All is well if everyone plays by the same rules of the road.

Real Estate Mortgages

The real problem is that the  value of real estate has decreased beyond the capacity of some homeowners to sustain.  Those who bought homes in the past 4 years or so, before the real estate bubble burst, are now holding negative equity in their homes. These homeowners are upside down, regardless of their ability to pay, and can not sell their home.  If they are not in default, they can not sell because they are required to pay any negative equity in order to close out their mortgage.  If no homes are bought or sold, the US economy will come to a dramatic halt. 

A short term solution to this problem is to follow the Bank of America model, allowing a mortgage reset or principal write down for those homeowners who are in this situation, postponing the payment of any negative equity that has accrued as a "bubble" payment at the end of their loan term.    By not modifying the total amount of the principal,  the mortgage is in fact "flat lined" to a positive value at the original loan origination date, when home values were presumably still increasing. 

What do we do with these "bubble payments" that must be paid at the loan's maturity, or at closing?  If we allow any positive equity to accrue to this depreciation by account, homeowners would reduce it in time, perhaps even clearing it out  of their mortgage account outright.  A positive "bubble" is an asset of the home owner at loan termination or closing, a negative "bubble" is his liability. 

There are historical solutions to solving negative equity at closing.  For this, we should look at banking systems in other nations, such as the Sharia system used in some Arab nations.  We can solve this problem, let us  not  be corralled into a panic that will only help the privileged few, but that will harm our  nation.  May guide us in these troubled times, we must seek His ways, they are just and ever lasting.

Atlanta, GA
Sep 24, 2008