Wednesday, February 27, 2008

Sub-prime bailouts loom large

Bailout cries are growing louder. In the guise of removing powerful headwinds that may prevent a strong recovery from any slowdown, Princeton Professor, Alan Blinder has lent his considerable academic reputation to the growing calls for bailing out mortgage holders facing foreclosures. He feels that a "potential tsunami of home foreclosures" will throw families (he however acknowledges that only "some" of them are victims of deception) into the streets, cut consumer spending, and create a meltdown in the larger financial markets.

He therefore calls for the creation of a New Deal type Home Owners’ Loan Corporation (HOLC), financed by borrowing from capital markets and the Treasury, that would buy old mortgages from banks — most of which would be delighted to trade them in for safe government bonds — and then issue new loans to homeowners. He estimates that the new version of HOLC will need to lend to 1-2 million mortgages, thereby borrowing and lending $200-400 bn to the most vulnerable types of mortgage holders. His figures even suggests that the HOLC 2.0 could make a profit!

He writes, "The HOLC had received about 1.9 million applications from distressed homeowners and granted just over a million new mortgages, thereby owning nearly one of every five mortgages in America. As a public corporation chartered for a public purpose, the HOLC was a patient and even lenient lender. It tried to keep delinquent borrowers on track with debt counseling, budgeting help and even family meetings. But times were tough in the 1930s, and nearly 20 percent of the HOLC’s borrowers defaulted anyway. So the corporation eventually acquired ownership of about 200,000 houses, nearly all of which were sold by 1944."

Alan Blinder's plan came even as a confidential proposal by the Bank of America warned that up to $739 billion in mortgages are at “moderate to high risk” of defaulting over the next five years and that millions of families could lose their homes. In order to prevent this, it suggests creation of a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates.

Such bailouts are in contradiction to the neo-classical arguments that "wounded financial markets are supposed to cure themselves: asset prices fall, bargain hunters rush in and markets return to normal", a standard prescription administered, often forcibly, on many developing countries and recently even Japan. The "moral hazard" possibilities of any bailout are enormous. It would mostly benefit banks and Wall Street firms that earned huge fees by packaging trillions of dollars in risky mortgages, often without documenting the incomes of borrowers and often turning a blind eye to clear fraud by borrowers or mortgage brokers. It is likely to encourage banks and home buyers to take outsize risks in the future, in the expectation of another government bailout if things go wrong again.

Proposals like that of Bank of America, envisages the government buying the mortgages at their true current value, perhaps through an auction, at probably a big discount from the original loan amount. The mortgage lenders, or the investors who bought mortgage-backed securities, would then be free of the bad loans but would still have to book their losses. They argue that if the government took control of the bad mortgages, it could restructure the loans on terms that borrowers could meet, keep most of them from losing their homes and avoid an even more catastrophic plunge in housing prices. Though the government might end up buying $80 billion to $100 billion in mortgages, it can recoup its money if it buys the mortgages at a proper discount, repackage them and sell them on the open market. But identification of the real needy beneficiaries will remain a major problem.

About 8.8 million homeowners, or 10.3 percent of the total, are facing the prospect of foreclosures. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

Update 1
On 11 March, 2008, the Federal Reserve offered to let the biggest investment banks on Wall Street borrow up to $200 billion in Treasury securities in exchange for hard-to-sell mortgage-backed securities as collateral. It also made clear that it was prepared to do more as needed. The move, which was coordinated with central banks in Europe and Canada, came on the heels of two similar actions last week, in which the Fed offered up to $200 billion in 28-day cash loans to banks and big financial institutions.

As Edmund Andrews writes, "The Federal Reserve, in effect, is trying to ease an acute credit squeeze by agreeing to hold large volumes of mortgage-backed bonds that Wall Street firms are struggling to sell and providing them with either cash or Treasury securities that they can immediately convert to cash." In recent days, market prices for seemingly safe debt had fallen so much that major financial institutions were being forced to put up more capital to secure their debt. The Fed appears to belive that the moral hazard dangers inherent in such bailouts are more than over-ridden by the much bigger danger of the credit squeeze dragging the whole economy into a deeper recession. The Fed’s hope is to relieve some of the pressure on institutions to sell at fire-sale prices, easing the strains on economic activity and making the credit markets feel more comfortable in buying mortgage bonds again.

The danger is that the central bank might make things worse in the long run by postponing the repricing of mortgage assets that financial institutions are holding, or by further weakening the value of the dollar and aggravating inflation.

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