Stabilize House Prices, Part 1

“We are in a vicious cycle: falling housing values cause losses on securities, which reduce bank capital, thereby tightening lending and causing house prices to fall further. The cycle has spread beyond housing, but housing is the place to fix it.” – R. Glenn Hubbard and Chris Mayer.

I find it very interesting that conservative economists, who have been and are, in general, against government regulation and interference, and who believe that government should allow a free market system to be free, are coming up with ideas to save us from the financial crisis. That these plans include and revolve around the U.S. government, and ultimately the tax payer, in a very big way can be construed as an indication of the economists’ new-found flexibility or an indication of how bad the financial crisis really is.  Or it may be the recognition that the U.S. government is already so heavily involved in the financial system that these economists are seeking to do the least amount of harm.

First, Let’s Stabilize Home Prices by R. Glenn Hubbard and Chris Mayer, which appeared in the October 2nd issue of The Wall Street Journal, is a good example.

Millions of homeowners owe more on their mortgage than their house is worth. Foreclosures are accelerating. House prices continue to fall, weakening household balance sheets and the balance sheets of financial institutions.

But this can stop. The price of a home is partially dependent on the mortgage rate — a lower mortgage rate raises house prices.

We propose that the Bush administration and Congress allow all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25% (matching the lowest mortgage rate in the past 30 years), and place those mortgages with Fannie Mae and Freddie Mac. Investors and speculators should not be allowed to qualify.

While the net cost is modest compared with many plans on the table, it would require that the government could assume trillions of dollars of additional mortgages on its balance sheet. But we have already crossed this bridge with the explicit “conservatorship” of Fannie Mae and Freddie Mac. In any event, these mortgages would be backed by houses and the verified ability to repay the debt by millions of Americans. In addition, by putting a floor under house prices, this proposal would raise the value to taxpayers of trillions of existing home mortgage assets already owned or guaranteed by the FDIC, the Fed, the Treasury, Fannie Mae and Freddie Mac, among others.

In addition to focusing on the very real problem in the housing market, the plan could be implemented immediately. As a result of the U.S. government’s conservatorship of Fannie Mae and Freddie Mac, origination of new mortgages can be financed quickly. Congress would have to raise the overall borrowing limit and approve the new federal purchases of negative equity loans. But it will likely take the Treasury much longer to buy troubled assets than Fannie and Freddie, and it would have to seek the involvement of many additional private actors, as opposed to using vehicles already in place.

To be continued …

“Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. Mr. Mayer is a professor of finance and economics and senior vice dean of Columbia Business School.”

photo credit: TheTruthAbout…

Criticism of the U.S. Bailout Plan, Part 3

“There is only one thing necessary to understanding what is happening and it is this: no one at US banks, no one at the Federal Reserve and no one in politics can accept the reality that real estate assets in this country remain oversupplied, overpriced and overleveraged.” – Greg Newton.

A Nation of Morons, Led by Idiots by Greg Newton is a humorous take on the government’s proposed bailout.

Maybe it’s not so funny.

Criticism of the U.S. Bailout Plan, Part 1

“The Devil Is In The Details” – Proverb

Joe Nocera’s September 19th column Hoping a Hail Mary Pass Connects in The New York Times offers some cogent criticisms of the U.S. government’s bailout program.

… the financial system has seized up. But so far, the government’s actions haven’t helped. Letting Lehman go bust may have sounded good at the time, but it has had disastrous consequences.”

It has led to complete chaos in the multitrillion-dollar market for credit-default swaps and was a crucial reason Morgan Stanley was forced to scramble to stay alive this week. It is also why questions were raised about the viability of Goldman Sachs, a firm with a pristine balance sheet and almost none of the bad assets that are bringing down other firms.

The rescue of A.I.G. further undermined confidence because, within the space of several days, the government did a complete about-face. The bailout suggested the Treasury Department was as confused about what to do as the rest of us.

So rather than help solve the crisis, the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence.

Nocera thinks that Criticizing Short Sellers is misleading at best.

The idea that short sellers are the cause of the problem “is more myth than fact, and in any case, it’s not the dynamic here.”

Stocks are falling because companies made huge mistakes that have caused them a heap of trouble. Indeed, in July and August, short interest in financial stocks declined by 20 percent. Why did the stocks continue to go down? Because there were too many sellers and not enough buyers: it’s that confidence thing again. Blaming the shorts is classic blame-the-messenger behavior.

While agreeing that we should save the Money Market Funds, he raises the question of moral hazard.

It bails out poorly managed money funds — the ones most likely to break the buck — at the expense of funds that haven’t taken the extra risk that causes a sudden drop in value.

And then there’s this: If you have your money in a bank account, only $100,000 is insured. But if you have it in a money market fund — which usually has a slightly higher yield precisely because it has a small element of risk — you now have unlimited insurance. It’s the world turned upside down.

Finally, when it comes to the actual Buying of Distressed Assets by the government, Nocera asks

How is the government going to assess these securities — and what price will it pay for them? In many cases, these securities aren’t being sold because they are still overvalued on a firms’ books. That is, their mark-to-market price is unrealistically high. Will the government buy it at the too-high price? If it does, the firms won’t have to take additional write-downs — but it will constitute a huge, unjustified bailout of Wall Street. (More moral hazard.)

But what if the government drives a hard bargain, and gets the securities for what they are really worth — 20 cents on the dollar, say, instead of 50 cents? In that case, the firms would have to take yet more enormous write-offs, which would further damage their balance sheets, and they would have to raise billions more in capital. Maybe the removal of these bad assets would allow the firms to raise the capital. But maybe not — meaning one or more could conceivably have to file for bankruptcy, creating yet another spasm of financial turmoil. It’s a huge roll of the dice by the government.

In conclusion, he says, “As much as we all hope the worst is over, it’s probably not.
And as much as we might hope that the government finally has the answer, it probably doesn’t.”

Not pretty, but there it is.