Why U.S. Borrowers Need Much More Than TARP

Small business owners face a tsunami of foreclosures. BW reader Samuel Bornstein says educating them is far more useful than bailing them out

Timothy Geithner, President Barack Obama's choice to be Treasury Secretary, stated during the Jan. 21 hearing on his nomination that the Obama Administration is considering a solution to the economic crisis that would entail returning to the original intent of the financial rescue initiative implemented by the George W. Bush Administration late last year. Known as the Troubled Asset Relief Program, or TARP, that effort was set up with the expectation that it would purchase so-called troubled assets. Now the Federal Reserve and the Federal Deposit Insurance Corp. are advocating creation of a government-backed bad bank—or aggregator bank—to acquire hundreds of billions of dollars of the troubled assets that have been clogging the balance sheets of banks and freezing the credit markets.

While troubled assets remain on banks' books, writedowns and losses will continue to cause economic havoc and drain the strength of the financial sector. In effect, the U.S. government—we, the taxpayers—will bear the losses on these toxic mortgages. There is growing concern that losses will continue to materialize as defaults increase; 8 million foreclosures are projected over the next four years.

Put simply, the underlying assets of the mortgage-backed securities and other related investments are toxic mortgages. The real troubled assets are the alt-A and option ARMs, interest-only mortgages woven into the mortgage-backed securities, collateralized debt obligations, and other derivative investments that are leveraged into trillions of dollars of obligations worldwide. Since the valuation of such toxic assets depends on the borrowers' ability to make monthly mortgage payments, the key to solving the economic crisis is the borrowers' financial health.

Financial Guidance for Debtors

Some observers are betting borrowers will default and foreclosures will follow. The high rate of foreclosures could have been expected because borrowers lacked financial guidance, as evidenced by the subprime mortgage crisis, out-of-control consumer spending and credit-card usage, and the spike in foreclosures and bankruptcies. Even after loan modification, the redefault rate has been 60% within six months.

The solution, I would argue, is a program of immediate and specific financial guidance that will help borrowers make monthly mortgage payments without needing bailouts or extensive loan modifications, which have proven to be a failure. The program that is needed is not the so-called financial literacy initiative—which simply disseminates information—but rather a true educational program to help borrowers understand how to manage their money and avoid the pitfalls that led to their financial distress.

The current foreclosure crisis will be further exacerbated by a tsunami of foreclosures that will result when these toxic mortgages are reset, a process that will continue through 2012. These foreclosures will dwarf the subprime mortgage crisis, leaving millions of small business owners in peril of losing their homes to foreclosure—and then potentially closing their businesses. The resulting job losses will add millions to the ranks of the unemployed.

Foreclosed Homes, Worker Layoffs

Small business owners fell prey to these toxic mortgages when they used their homes to access cash to satisfy their need for capital. They were enticed into taking toxic mortgages by initial teaser rates with low monthly mortgage payments, but were unaware of the payment shock that would follow at reset. Because these loans required little or no documentation of income, they appealed to many small business owners who previously were unable to qualify for loans—and who were especially targeted by lenders.

I authored a survey conducted by the National Association for the Self-Employed in November 2008, which found that 3.7 million small business owners hold these toxic mortgages. Three million of them are already very worried that they will not be able to afford the monthly mortgage payments at reset; more shocking is the fact that 1.3 million small business owners have already missed at least one monthly mortgage payment. The survey results underscore the fact that small businesses will be impacted by the upcoming foreclosures.

It is a tragedy when an individual borrower defaults on a mortgage and loses his or her home. The tragedy is magnified when the borrower owns a small business with 1 to 10 employees. The loss of jobs related to mortgage defaults and the resulting business failures will further weaken our economy and prolong the recession.

If borrowers can be guided to avoid defaulting, the financial and housing markets should respond favorably. The result will reverse the downward trend in the valuation of troubled assets. We can turn this crisis around and stimulate the economy naturally, by empowering and educating people rather than by bailing them out—which does not, as the cliché goes, teach a man to fish.

As I concluded in my NASE study, small business is the job creation engine of our economy. Proactive efforts must be taken to provide small business owners with immediate and specific financial guidance. Combined with other measures, these can help vital borrowers avoid default on mortgages and other debts in this critical and challenging financial crisis.

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