Real Estate Lender Implosion

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The Bankers' Bailout
Feb 19 2008

Washington is quietly planning a massive rescue for banks stuck in the subprime mess. Does anybody really think Wall Street deserves to be bailed out?

Since the onset of the subprime crisis last summer, the White House has repeatedly rejected the notion of a government bailout, either for homeowners facing foreclosure or for the banks and mortgage companies that made the now souring loans. "There's no bailout with government money, none whatsoever," Treasury Secretary Hank Paulson emphasized. But even as the administration has stuck to its laissez-faire stance in public, behind the scenes a covert bailout has been under way, with a number of public and quasi-public agencies quietly dispensing vast sums to financial institutions saddled with worthless or near worthless mortgage securities. All the while, homeowners at the heart of the problem have been left largely to their own woes. The rescue operation brings to mind John Kenneth Galbraith's dictum that in the United States, the only respectable form of socialism is socialism for the rich. (Read about some former government bailouts.)

Let's start with the Federal Reserve. In addition to bringing down the federal funds rate from 5.25 percent last August to 3 percent—including a dramatic three-quarter-point cut one day in late January—the central bank recently introduced a new auction process that makes it easier (and cheaper) for cash-strapped financial institutions to borrow from the government. Through four auctions in December and January, the Fed lent dozens of financial firms $100 billion at rates well below the discount rate, the rate at which distressed lenders formerly had to borrow. Crucially, the Fed also expanded the range of collateral it accepts to include triple-A-rated asset-backed securities, the same toxic paper that institutions like Citigroup and Merrill Lynch have been unable to sell or even value because the market for it has dried up. In effect, the Fed has been acting as a benevolent pawnbroker, extending cash for illiquid goods and charging low interest rates.

Then there is the Federal Home Loan Bank system, an obscure institution that President Herbert Hoover set up in 1932 to stimulate mortgage lending. The F.H.L.B., actually 12 government-chartered but privately owned regional banks, exploits its semiofficial status to raise money cheaply in the bond market and lends the proceeds to its membership, including most of the nation's big banks and investment firms. Since last summer, the F.H.L.B. has been extending low-cost credit at an unprecedented rate—$184 billion in the third quarter alone. Recipients include Citigroup, which owed the F.H.L.B. $98.7 billion at the end of September; Countrywide Financial, which owed $51.1 billion; and Washington Mutual, owing $43.7 billion.

Finally, there are Fannie Mae and Freddie Mac, which are also government-chartered but privately owned institutions. Fannie and Freddie do two things: They encourage other lenders to issue home loans to low- and middle-income families, and they raise money in the bond market to buy mortgage-backed securities. Despite losing money during the third quarter of 2007, the two mortgage giants stepped up their issuing and buying, often in tandem with the very Wall Street players that are now suffering. In fact, while many companies were drastically downsizing their mortgage divisions, Fannie and Freddie still did great business.

As a result of all this government-sanctioned activity, total mortgage lending nationwide actually rose in the third quarter of 2007, according to Richard Iley, an economist at BNP Paribas. However, as he pointed out in a recent research note, simply increasing the volume of business was probably not the only goal. "It is no exaggeration to say that the mortgage market was effectively nationalized" in the third quarter, Iley wrote. "The F.H.L.B. acted as a forgiving lender of the last resort, providing the liquidity to sustain mortgage production while Fannie and Freddie acted as risk intermediaries of last resort with record purchases of mortgages."

The government lending operation prevented the mortgage industry from seizing up, but it didn't solve the underlying problems facing the housing market. The question is whether more drastic measures will be needed to help lenders as well as borrowers. For the past three months, the widely watched S&P/Case-Shiller home price index has shown prices sliding at an annual rate of more than 15 percent across the country, with bigger falls in some areas. One in five subprime mortgages is already in arrears, and the delinquency rate is rising. Even more worrying are recent developments involving products like option ARMs, adjustable-rate mortgages that allowed borrowers to make such small monthly payments that their loan balances sometimes increased. The Los Angeles Times reports that in many parts of California, delinquency rates on option ARMs have reached double digits. Even on old-fashioned fixed-rate loans, the number of foreclosures is edging up. "This is turning into a human calamity," says Lou Ranieri, the Wall Street veteran who in the 1970s helped found the mortgage-backed-securities market. "We are looking at numbers that start to rival the Great Depression in terms of people hurt."

In an election year, pressure for more action is sure to intensify. The stimulus package working its way through Congress includes a proposal to let Fannie and Freddie buy mortgages worth up to nearly $730,000.

Hillary Clinton advocates a 90-day moratorium on subprime foreclosures as well as allocating more federal money to alleviate the housing crisis by, for example, purchasing vacant properties and renting them to working families. Other candidates have their own proposals.

Alan Greenspan has pointed out that rather than going through the trouble of negotiating with mortgage lenders and imposing rate freezes, the federal government could just send checks to distressed borrowers, which they could use to meet their monthly payments. The former Fed chairman, a free-market conservative, backed the handout nonetheless: He said that if the government wanted to bail out struggling homeowners, this would be a more efficient and transparent way to go, which is surely true.

A similar argument applies to the quasi-governmental agencies. Instead of relying on Fannie, Freddie, and the F.H.L.B. to ease the credit crunch, the federal government might be well advised to intervene directly in the financial markets. One solution is for the Fed, the Treasury Department, or a new official entity to buy large amounts of mortgage-backed securities, collateralized debt obligations, and other distressed paper from financial firms at bargain-basement prices. By purchasing these assets at a discount, the government could ensure that companies pay heavily for their reckless behavior, while also injecting much-needed liquidity into the system.

Such an initiative has historical precedents, and it wouldn't necessarily break the federal budget. In 1933, President Franklin D. Roosevelt founded the Home Owners' Loan Corp., which refinanced about a million troubled mortgages during the Depression. In 1989, Congress set up the Resolution Trust Corp. to take over more than 700 bankrupt savings and loans. Some experts predicted that the R.T.C. would end up spending $100 million or more, but by holding on to some of the S&Ls' assets until the economy and property values rebounded, it was able to keep its net spending to $87.9 billion. Adding in other expenses, such as those incurred by the R.T.C.'s predecessor, the Federal Savings and Loan Insurance Corp., the total cost to taxpayers of resolving the S&L crisis was $132 billion—in today's money, about $180 billion.

At this stage, the subprime crisis is still smaller than the S&L debacle: About 150 mortgage companies have been sold or gone under. Benn Steil, an economist at the Council on Foreign Relations, and Mark Fisch, a managing partner at Continental Properties, guesstimate that an R.T.C.-style subprime rescue could cost up to $75 billion. As part of the $3 trillion federal budget, this would be a perfectly manageable sum. There isn't much political support for such a dramatic move, however, so Wall Street is hobbling along on a combination of gradual write-offs and capital injections from foreign governments.

But one big financial collapse or near-collapse could change the climate overnight. How likely is such a catastrophe? Consider Merrill Lynch, one of the worst offenders in the subprime mess but an instructive example nonetheless. Last summer, before the credit crunch began, Merrill had total assets of roughly $1.1 trillion perched on top of equity capital of roughly $40 billion. With a leverage ratio of 25.3, it was in a situation where a mere 4 percent fall in the value of its assets would wipe out all of its capital. Such thinly capitalized financial firms are at the mercy of their lenders. If a crisis of confidence develops, funding can dry up and the firms can unravel with stunning rapidity.

Fortunately for Merrill, the full scale of its exposure to the subprime problem emerged gradually, and so far it has been able to secure fresh capital and stabilize its finances. The next casualty might not be so lucky. Much depends on the degree to which credit problems extend from subprime to other areas in which securitization was popular, such as home-equity loans, commercial real estate, corporate loans, credit-card receivables, and auto loans. If these sectors deteriorate—and recent reports from American Express, Citigroup, and other firms indicate some disturbing trends—more big financial firms will find themselves with holes in their balance sheets, and persuading others to bail the firms out may be difficult. (Presumably, even the governments of Dubai and Abu Dhabi have limits on their largesse.)

Since letting a major bank or Wall Street firm fail in the current environment could easily lead to contagion, the federal government would have little option but to launch a formal rescue. This is what happened in May 1984 when Continental Illinois, which was stuffed full of bad loans that had been extended to the oil patch, found itself shut out of its usual funding markets. The Federal Deposit Insurance Corp. injected $4.5 billion into Continental, removed the senior management, and took an equity stake of 80 percent. The bank continued to do business, albeit in a scaled-back manner; eventually it was sold to Bank of America.

GaveKal, a Hong Kong economics consultancy, says that this financial crisis, like those that preceded it, began with government at arm's length. But as in past rescues, that government resistance eventually begins to soften. "In each of these cases, the interventions were undertaken by doctrinaire free-market governments—and in each case, they worked," GaveKal's report states. Evidently, in order to save capitalism, it is sometimes necessary to administer a stiff dose of socialism.


http://www.portfolio.com/views/columns/economics/2008/02/19/Massive-Bailout-Planned-for-Banks