A Proposed Solution to the Credit Crunch in Housing That You Won't Read in the Mainstream Media
THE FOLLOWING COMMENTARY WAS DELIVERED OVER WAMC RADIO BY MICHAEL MEEROPOL on SEPTEMBER 7, 2008
On Friday, August 31, three important news items dealt with the current housing crisis. In one, Ben Bernanke, the Chairman of the Federal Reserve Board, stated that the central bank "stands ready to take additional actions as needed" to prevent, "the chaos in mortgage markets from derailing the broader economy." 1
Bernanke was promising lenders and borrowers that the FED would turn on the money spigot to counter the market jitters. Meanwhile, President Bush offered a series of steps to "help … Americans with credit problems avoid losing their homes ..." 2
Implicit in both Bernanke's promise and Bush's proposals was the goal of avoiding foreclosure by helping borrowers continue to make payments. Unstated was the corollary that this would make it more likely that the lenders who made these poor investments would get their full rate of return.
The third item was an OP ED piece in the Providence Journal.3 In it, Dean Baker and Andrew Samwick begin with the following premise:
"It is important that policy be focused on assisting financially strapped homeowners, not lenders that issued deceptive mortgages or investors who foolishly speculated in mortgage-backed debt." They want to "allow troubled homeowners to stay in their homes without also bailing out the mortgage issuers and speculators."
Their key recommendation is for Congress to pass a law capping the monthly payments at a home's fair market rent. Deceptive advertising has led homeowners to purchase houses at prices they cannot truly afford. New markets in liquid mortgages have made lenders less careful about buying securities containing those mortgages.
A typical economist's response is that both parties must accept the consequences of their "poor choices" - the homeowner must be forced out of his/her home and the mortgage holder must take a loss.
Baker and Samwick argue that the important group to rescue is the homeowners not the lenders.
Their solution does not reward lenders -- it punishes them by forcing them to accept a loss on the mortgage securities they've bought while protecting homeowners from foreclosure.
Why is this a better solution than the ones we are reading about coming out of Washington? The answer is in an understanding of why the situation has become so dire.4 The current problem to a large extent stems from the emergence of the housing bubble. Bubbles work on the principal of the "bigger fool" theory - I know I'm buying something that's costing much more than it's really worth but I also know that when the time comes I can sell it to a "bigger fool" than I am.
Sooner or later speculators discover that they are the "biggest fools" -- they cannot find a buyer -- they have to sell at a loss. This is true for money managers who have bought securitized mortgages as well as for homeowners who bought a house they truly couldn't afford at a mortgage whose terms they didn't really understand.5
Bailing out lenders sends a message that they can behave irresponsibly in the future and get away with it.
The Baker-Samwick solution has the great virtue of penalizing them for their bad investments by significantly cutting their rate of return.
I fear that Congress and the President will respond with something much more to the liking of the speculators and the Federal Reserve will do the only thing it knows how to do, cut interest rates.
Too bad. The Baker-Samwick proposal is a good one. Maybe you can suggest that your member of Congress support it?
Footnotes:
1 The New York Times: September 1, 2007: "Bernanke Says Fed is Prepared for More Action" (p. 1) Since then, there appears to be a consensus among financial and economic prosnosticators that the Federal Open Market Committee will lower the federal funds rate, it's benchmark short term interest rate, by either ¼ or ½ of a percent.
2The New York Times: ibid. "On Mortgages, Bush Plans a Limited Intervention." [B1]. In this article, President Bush quite rightly notes that "A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators, or those who made the decision to buy a home they knew they could never afford." It is in his last sentence where President Bush erroneously creates an equivalence between the victims of shady lending processes and the perpetrators. Obviously no one buys a home knowing "they could never afford"(emphasis added) it. They were tricked into believing they could afford that home by deceptive lending practices. According to the article (p. B6) a half a million homeowners are in danger of foreclosure because of already missed payments. The Bush proposal will make it easier for some low income mortgage holders to get federal mortgage insurance - that would help about 80,000 but it would really help the very speculators Bush said he didn't want to help. If these folks get federal mortgage insurance, then the speculators who bought those mortgages won't lose money on them. Much worse, by the way, are some proposals by Congressional Democrats that would use Fannie Mae and/or Freddie Mac to come to the rescue of hard-pressed homeowners and thus, on a much larger scale, validate the bad investment choices of speculators.
3 This article ran in the Providence Journal on September 3. I consider it so valuable that I recommend that it be read in its entirety. Read the article
4 And it has become so dire not just for the homeowners who are in danger of losing their homes but for the economy as a whole. As home prices across the country fall, construction activity falls. The construction industry is an important component of investment. As it declines, job growth slows. (The August job figures were quite disappointing - a predicted increase turned into a decline.). Another important fact is the the rising values of homes had been a major source of consumer spending. In effect, consumers who owned homes were using the rising equity in their homes as an ATM machine to increase consumption spending. That has stopped --- and as home values fall, homeowners will have to cut back on spending just to stay in their homes. As we move through September, economists are recognizing the possibility of a recession sometime before the year is over.
Dean Baker goes much further. He put it this way in an on-line commentary ("Alan Greenspan and His Bubbles" By Dean Baker CENTER FOR ECONOMIC POLICY RESEARCH September 18, 2007:)
"[T]he biggest effect will be the impact that the loss of housing wealth will have on consumption. As the bubble expanded, people borrowed against housing equity almost as rapidly as it was created. The Fed estimated that a dollar of housing wealth translates into 5 cents of additional consumption. This story works in reverse also. A loss of $4 trillion in housing wealth will lead to a reduction of approximately $200 billion in annual consumption. This drop in consumption, coupled with the downturn in the housing sector, virtually guarantees a recession, and quite likely a very severe recession."
5 One example of fine print coming to bite homeowners was highlighted in the New York Times of September 13. "A Home Loan Trap." (C1). The article notes that individuals who bought mortgages at initial low rates with the hope of paying them off when the rates rose are finding themselves hit with so-called "exit fees." These are penalties for paying off the mortgage earlier or refinancing. In other words, many people who were induced to buy homes with low "teaser" interest rates were under the impression that they could just pay off the loan when the rates started to adjust upwards. On the contrary, they are begin hit with large penalties - so large that selling the house and paying the penalty will actually consume all the equity they have. The problem for the money managers is spelled out in an excellent article by Roger Lowenstein in the New York Times Magazine on September 2. ("Subprime Time: How did Homeownership become so rickety?" pp. 11-12). Lowenstein describes the process of turning illiquid assets, mortgages on homes, into liquid assets, securities backed by mortgages on homes. "Even though each unit of real esates continued to be a slow-moving, illiquid asset, … the underlying mortgages could be traded as rapidly as stocks and bonds. Instead of keeping his mortgages in a drawer, the banker on Main Street could unload his risk by selling them to Salomon [Brothers]. The banker was thus converted from a long-term lender to a mere originator of loans. Salamon and other institutions would take the mortgages sold by banks and stitch together bonds backed by the payments of many mortgagees, which they dsold to investors. … a group of inert mortgages [were now] a tradable security. … Once the mortgage originator became, in effect, a supplier to Wall Street, new, often unregulated nonbanking companies jumped into the game of brokering and also issuing mortgages. Over time, this weakened lending standards…" Lowenstein concluded, "What happened over the last generation is that housing was turned from a market that responded to consumers to one largely driven by investors." The bubble that fueled the dot.com boom of the late 1990s was replaced by a similar bubble in homebuilding and investing since 2002. The second bubble was why the recession of 2001-2002 while experiencing a significant decline in investment spending, saw no drop in consumer spending. Unfortunately, that situation is ending now. One other impact of the housing bust is that lenders are now doubly shy of getting caught investing in securities of dubious value. This may lead to a credit crunch similar to the one that caused a very sluggish housing and construction market after the Savings and Loan meltdown of 1989 and beyond. A credit crunch will mean even legitimate investors will find it difficult to borrow funds for new investments, compounding the negative impact of the fall in consumption spending.
On Friday, August 31, three important news items dealt with the current housing crisis. In one, Ben Bernanke, the Chairman of the Federal Reserve Board, stated that the central bank "stands ready to take additional actions as needed" to prevent, "the chaos in mortgage markets from derailing the broader economy." 1
Bernanke was promising lenders and borrowers that the FED would turn on the money spigot to counter the market jitters. Meanwhile, President Bush offered a series of steps to "help … Americans with credit problems avoid losing their homes ..." 2
Implicit in both Bernanke's promise and Bush's proposals was the goal of avoiding foreclosure by helping borrowers continue to make payments. Unstated was the corollary that this would make it more likely that the lenders who made these poor investments would get their full rate of return.
The third item was an OP ED piece in the Providence Journal.3 In it, Dean Baker and Andrew Samwick begin with the following premise:
"It is important that policy be focused on assisting financially strapped homeowners, not lenders that issued deceptive mortgages or investors who foolishly speculated in mortgage-backed debt." They want to "allow troubled homeowners to stay in their homes without also bailing out the mortgage issuers and speculators."
Their key recommendation is for Congress to pass a law capping the monthly payments at a home's fair market rent. Deceptive advertising has led homeowners to purchase houses at prices they cannot truly afford. New markets in liquid mortgages have made lenders less careful about buying securities containing those mortgages.
A typical economist's response is that both parties must accept the consequences of their "poor choices" - the homeowner must be forced out of his/her home and the mortgage holder must take a loss.
Baker and Samwick argue that the important group to rescue is the homeowners not the lenders.
Their solution does not reward lenders -- it punishes them by forcing them to accept a loss on the mortgage securities they've bought while protecting homeowners from foreclosure.
Why is this a better solution than the ones we are reading about coming out of Washington? The answer is in an understanding of why the situation has become so dire.4 The current problem to a large extent stems from the emergence of the housing bubble. Bubbles work on the principal of the "bigger fool" theory - I know I'm buying something that's costing much more than it's really worth but I also know that when the time comes I can sell it to a "bigger fool" than I am.
Sooner or later speculators discover that they are the "biggest fools" -- they cannot find a buyer -- they have to sell at a loss. This is true for money managers who have bought securitized mortgages as well as for homeowners who bought a house they truly couldn't afford at a mortgage whose terms they didn't really understand.5
Bailing out lenders sends a message that they can behave irresponsibly in the future and get away with it.
The Baker-Samwick solution has the great virtue of penalizing them for their bad investments by significantly cutting their rate of return.
I fear that Congress and the President will respond with something much more to the liking of the speculators and the Federal Reserve will do the only thing it knows how to do, cut interest rates.
Too bad. The Baker-Samwick proposal is a good one. Maybe you can suggest that your member of Congress support it?
Footnotes:
1 The New York Times: September 1, 2007: "Bernanke Says Fed is Prepared for More Action" (p. 1) Since then, there appears to be a consensus among financial and economic prosnosticators that the Federal Open Market Committee will lower the federal funds rate, it's benchmark short term interest rate, by either ¼ or ½ of a percent.
2The New York Times: ibid. "On Mortgages, Bush Plans a Limited Intervention." [B1]. In this article, President Bush quite rightly notes that "A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators, or those who made the decision to buy a home they knew they could never afford." It is in his last sentence where President Bush erroneously creates an equivalence between the victims of shady lending processes and the perpetrators. Obviously no one buys a home knowing "they could never afford"(emphasis added) it. They were tricked into believing they could afford that home by deceptive lending practices. According to the article (p. B6) a half a million homeowners are in danger of foreclosure because of already missed payments. The Bush proposal will make it easier for some low income mortgage holders to get federal mortgage insurance - that would help about 80,000 but it would really help the very speculators Bush said he didn't want to help. If these folks get federal mortgage insurance, then the speculators who bought those mortgages won't lose money on them. Much worse, by the way, are some proposals by Congressional Democrats that would use Fannie Mae and/or Freddie Mac to come to the rescue of hard-pressed homeowners and thus, on a much larger scale, validate the bad investment choices of speculators.
3 This article ran in the Providence Journal on September 3. I consider it so valuable that I recommend that it be read in its entirety. Read the article
4 And it has become so dire not just for the homeowners who are in danger of losing their homes but for the economy as a whole. As home prices across the country fall, construction activity falls. The construction industry is an important component of investment. As it declines, job growth slows. (The August job figures were quite disappointing - a predicted increase turned into a decline.). Another important fact is the the rising values of homes had been a major source of consumer spending. In effect, consumers who owned homes were using the rising equity in their homes as an ATM machine to increase consumption spending. That has stopped --- and as home values fall, homeowners will have to cut back on spending just to stay in their homes. As we move through September, economists are recognizing the possibility of a recession sometime before the year is over.
Dean Baker goes much further. He put it this way in an on-line commentary ("Alan Greenspan and His Bubbles" By Dean Baker CENTER FOR ECONOMIC POLICY RESEARCH September 18, 2007:)
"[T]he biggest effect will be the impact that the loss of housing wealth will have on consumption. As the bubble expanded, people borrowed against housing equity almost as rapidly as it was created. The Fed estimated that a dollar of housing wealth translates into 5 cents of additional consumption. This story works in reverse also. A loss of $4 trillion in housing wealth will lead to a reduction of approximately $200 billion in annual consumption. This drop in consumption, coupled with the downturn in the housing sector, virtually guarantees a recession, and quite likely a very severe recession."
5 One example of fine print coming to bite homeowners was highlighted in the New York Times of September 13. "A Home Loan Trap." (C1). The article notes that individuals who bought mortgages at initial low rates with the hope of paying them off when the rates rose are finding themselves hit with so-called "exit fees." These are penalties for paying off the mortgage earlier or refinancing. In other words, many people who were induced to buy homes with low "teaser" interest rates were under the impression that they could just pay off the loan when the rates started to adjust upwards. On the contrary, they are begin hit with large penalties - so large that selling the house and paying the penalty will actually consume all the equity they have. The problem for the money managers is spelled out in an excellent article by Roger Lowenstein in the New York Times Magazine on September 2. ("Subprime Time: How did Homeownership become so rickety?" pp. 11-12). Lowenstein describes the process of turning illiquid assets, mortgages on homes, into liquid assets, securities backed by mortgages on homes. "Even though each unit of real esates continued to be a slow-moving, illiquid asset, … the underlying mortgages could be traded as rapidly as stocks and bonds. Instead of keeping his mortgages in a drawer, the banker on Main Street could unload his risk by selling them to Salomon [Brothers]. The banker was thus converted from a long-term lender to a mere originator of loans. Salamon and other institutions would take the mortgages sold by banks and stitch together bonds backed by the payments of many mortgagees, which they dsold to investors. … a group of inert mortgages [were now] a tradable security. … Once the mortgage originator became, in effect, a supplier to Wall Street, new, often unregulated nonbanking companies jumped into the game of brokering and also issuing mortgages. Over time, this weakened lending standards…" Lowenstein concluded, "What happened over the last generation is that housing was turned from a market that responded to consumers to one largely driven by investors." The bubble that fueled the dot.com boom of the late 1990s was replaced by a similar bubble in homebuilding and investing since 2002. The second bubble was why the recession of 2001-2002 while experiencing a significant decline in investment spending, saw no drop in consumer spending. Unfortunately, that situation is ending now. One other impact of the housing bust is that lenders are now doubly shy of getting caught investing in securities of dubious value. This may lead to a credit crunch similar to the one that caused a very sluggish housing and construction market after the Savings and Loan meltdown of 1989 and beyond. A credit crunch will mean even legitimate investors will find it difficult to borrow funds for new investments, compounding the negative impact of the fall in consumption spending.
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