By Arnold Kling
According to Felix Salmon,
take a borrower who’s underwater, with a mortgage for more than their house is worth. Refinance the mortgage so that it comes down to the value of the house, and then give the lender a tradeable warrant for the difference. Mortgage payments come down, because the mortgage has come down, and the lender, if it needs cash, can simply sell the warrant on the secondary market. If the house gets sold for more than the value of the new mortgage, the excess goes in the first instance to the warrant holder; the homeowner makes money only if the house is sold for more than it was bought for.
I called it Bailie Mae, because whoever trades the loan amount for the equity piece is probably going to end up on the short end. I figured we’d need a government agency to do that.
I’m not sure who Bailie Mae is supposed to be in the OTS proposal. Suppose X is servicing the loan (collecting the payments), but the loan is bundled in a security owned by a whole bunch of different folks. Does X play the role of Bailie Mae? As a mere servicer, X had no participation in the mortgage cash flows before, so why would X want to participate now, on adverse terms?
With a securitized loan, I would think that the mortgage pool owners would have to replace some of the debt with equity. And then you have to figure out how to divide up that transaction. Sounds pretty ugly. That’s why I assumed that the idea needed Bailie Mae. But if they can figure out a way to turn the security owners into Bailie Mae, more power to them.