You may have heard me call him the “Mortgage Curmudgeon.”

Jack Guttentag is a retired professor of finance at the Wharton School of the University of Pennsylvania and an expert on the mortgages. I respect his opinion tremendously.

He believes the credit rescue plans proposed by the Federal Reserve and currently being discussed in Congress are “a disaster in the making.”

But he also offers a solution to the credit crisis.

Current Proposals

This mammoth transaction, which could have ramifications lasting decades, is a disaster in the making… It will provide taxpayer gifts to every selling firm, with no quid pro quo… And since there are no existing institutions to execute the plan, implementation could become the boondoggle of the century.

Yep. A huge new bureaucracy would be needed and it would be politicized immediately.

Who benefits most

Who would benefit most from the mortgage auction plans currently being discussed?

Bids would have to be expressed as a percent of face value, which has little relationship to market value. The firms that would benefit the most are those with the worst assets that meet the eligibility requirements of the auction. There is no reason to believe that these firms are also the ones most likely to suffer a cash shortage that would threaten their survival.

So the government would buy the worst mortgages which would help those lenders who took the greatest risks or committed the most fraud and who are least worthy of receiving any help at all.

The Result

Government as Owner: After the auction, the government would own the mortgages that it had purchased. Because it has gifted the sellers, it will be under enormous pressure to gift the borrowers as well. But if it does this a chasm will open between the treatment of those borrowers and the borrowers who were left behind because their mortgages were not sold. From the borrowers’ standpoint, whether they are in one category or the other is completely arbitrary.

It is unlikely that the government could resist the political pressure to gift its borrowers. Would it require other investors to provide the same breaks to their borrowers? Or would the government feel compelled to go back into the market and buy up the rest of the loans? These are frightening possibilities.

A nightmare scenario! But very realistic if the current plans being discussed are passed by Congress.

The Solution

A far better approach is to allow mortgages and mortgage securities to be used as collateral for loans. This would extend the traditional lender-of-last-resort function, which has already been extended to cover investment banks and insurance companies, to everyone who can post acceptable collateral.

It’s a concept with a successful track record…

In addition, this approach could be implemented through the existing Federal Home Loan Banks, as lending on the basis of mortgage collateral is what they do.

… that can be carried out through an established institution.

The Alternative Approach: A loan program will provide cash to firms with acceptable collateral, rather than to firms that bid successfully in an auction. Further, following traditional lender-of-last-resort practice, the government would charge a penalty interest rate high enough to discourage borrowing for the purpose of relending at a profit.

Implementation: The Federal Home Loan Banks have been in the business of making loans collateralized by mortgages since 1935, and they have all the required systems, including systems for valuing and safe-guarding mortgage collateral. Under existing rules, the banks lend only to their members. Under the rules applicable to the new program, they would lend to a larger list, which should include any firm (including hedge funds and foreign-based firms) that can post collateral acceptable to the banks. To move this program forward, the banks require only the new rules specifying authorized sellers and acceptable collateral, plus incremental funding.

Sounds good to me!