Greetings all,

After unsuccessfully trying to share my thoughts at the federal level, I am urging you to consider my suggestions for applying them at the state level. My background includes being a Vice President in Merrill Lynch's SPS group, serving as technical liaison to its business group handling CMOs and ABSs, about which much there has been much generalization and misinformation during this crisis. CMOs, particularly the credit risk tranches, were intended to deal with prepayment risk, of which defaults in a stable real estate market could be considered one form. The tranches allocated the risk and return to the investors in that tranche independently of the other tranches. The introduction of default swaps and subprime mortgages produced a financial structure which was much more vulnerable to a collapse in the real estate market by simultaneously increasing the risks and circumventing the defenses of CMOs.

However, the danger has always been there and would have existed even if there were no CMOs. The danger of a speculative bubble in the mortgage market which eventually bursts is inherent in the very nature of the mortgage instrument. The mortgage is the most readily available instrument for leveraging and therefore most likely to be widely abused. The leveraging is a consequence of the inequitable distribution of risk from fluctuations in the value of the property being invested in or "financed".

For comparison purposes, consider investment in a publicly traded company in a clean classical case, with no preferred shares. If I purchase 5,000 of the 500,000 shares in a company worth $500,000 at the time of purchase, my investment is $5,000. If the company's value increases to one million a year later, the value of my investment also doubles to $10,000. If the company's value declines to $250,000, then my investment also declines by half to $2,500. At every point, my investment moves in the same direction and to the same degree as the total value. Alternatively, we can say that the value of my investment is the current value of the company times my percentage equity stake, in this case 1%.

The conventional mortgage does not work so fairly. Instead, regardless of the equity stake I may have in the house, the value of my investment is the total value of the house. If I buy the house with no payment down and not too much time has elapsed, or a longer time with a balloon mortgage has elapsed, or if I paid 1% down and have made no payments affecting principal, I might have a 1% equity stake in a house with a remaining principal of $495,000 from the original purchase price of $500,000. For an investment with the same equity stake as the stock example, I have leveraged a value of $500,000. This is a two-edged sword, though. Yes, if the house value doubles, my $5,000 has produced a $505,000 net value if I sell, and I can rejoice in the wonders of leveraging while the lender is denied the $990,000 value that fairly represents his 99% equity stake in this boon. But if the house value halves, my $5,000 has resulted in a loss of $245,000 if I have to sell. In an economic downturn that would normally accompany such a reduction of house values in an area, I would have to sell if I can take the loss and, if not, I would stop my payments and the lender would foreclose and be confronted with the same loss. In the last case, the risk is finally borne by the holder of the greatest equity stake, but this belated fairness has occurred with severe damage to my credit rating and the loss of my entire small equity stake. In addition, I am homeless when I can least afford to be.

A fairer mortgage instrument would be what I have called an Adjustable Equity Mortgage or AEM. With this instrument, the total equity is adjusted proportionate to change in the appraised market value of the mortgaged property. The original total equity would be the downpayment plus the original principal. Periodic appraisals would adjust the principal and the monthly payment by the ratio of current appraised market value(total equity) over the last previous appraised market value(total equity), keeping the equity value of borrower and lender at their respective equity stakes times the current appraisal. The role of the State, absent the Third Bank of the United States which I have been advocating, would be to overturn recent foreclosures and prevent threatened foreclosures by requiring the existing mortgages be converted to AEMs, re-amortizing if necessary. Indeed, the fairness of this instrument removes in large measure the causes of foreclosure and even provides an avenue for avoiding them altogether with sales to the State at appraisal value, preserving the good credit of those who are otherwise responsible borrowers and allow them to seek more affordable housing with a new AEM.

Please feel free to contact me if you wish to discuss this further.

Thank you for your time and attention.

Sincerely,

Carl Peter Klapper