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End Bailouts—No Ifs, Ands, or Buts

It's hard to imagine, but it looks like the beleaguered U.S. housing market faces further travails. And that means the financial system could be entering another perilous phase, especially since the economy continues to sputter. But this time around the U.S. Treasury and the Federal Reserve should send a clear message up front to the top brass at big financial firms: no more bailouts.

The latest setback for U.S. housing reflects growing doubts about the foreclosure procedures of the major mortgage loan servicers, such as Bank of America (BAC) and JPMorgan Chase (JPM). The servicers are attempting to label foreclosure procedure problems as clerical errors, but the message isn't gaining traction. Instead, the attorneys general from every state announced on Oct. 13 that they are investigating the loan servicers for questionable foreclosure practices.

Major federal regulators are looking into foreclosures, too, including the Securities & Exchange Commission and the Federal Housing Finance Agency.

The foreclosure investigations ratchet up the market uncertainty enveloping the already fragile housing market. Who wants to buy a foreclosed property without clear title, let alone a securitized package of mortgages?

Specter of Forced Buybacks

The picture gets even uglier. Big investors are starting to exercise the rights written into many mortgage-backed securities requiring banks to buy back loans gone bad. For instance, Bank of America's market value dropped 3.4 percent on Oct. 19 on reports that three giant investors—Pacific Investment Management Co. (Pimco), BlackRock, and the Federal Reserve Bank of New York—want the lender to repurchase $47 billion of securitized mortgage bonds.

There is a genuine probability that the mortgage-backed packagers could be on the hook for billions of dollars. Analysts at JPMorgan Chase estimated in an Oct. 15 report that the put-back price tag could reach as much as $80 billion.

The Obama Administration hasn't done much to address the latest developments in the housing market. Bravo. A hands-off approach is appropriate even though odds are many financial institutions will pay a steep price for the credit spree that ended disastrously with the credit crunch three years ago. Congress is hardly willing to contemplate another bailout. Foreclosure law is primarily a state issue. The courts are the proper venue for sorting out the fight between big investors and mortgage-backed securities packagers.

But the Administration should go farther. Seize the opportunity to tell bank managements bluntly that even in a worst-case scenario, "You're on your own. Oh, and by the way, we won't make management, shareholder, or creditors whole if you get into trouble."

Seize and Liquidate

That's right, the government should make its intentions clear that it will exercise the power authorized by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and seize and liquidate any of the nation's biggest bank holding companies or investment banks if their deteriorating finances threaten the economy. A forceful stand like this will greatly reduce the risk that the combination of bad foreclosures and sour mortgage loans will create another financial catastrophe on the scale of September 2008.

There's another reason for acting tough now: It's payback time, and not in the petty sense of the phrase. No, the U.S. economy is at a "moral hazard" juncture. Moral hazard is a phrase economists use to describe the likelihood that the incentive to take greater and greater risks grows once management believes the government will bail them out whenever big bets go really bad.

Risk-taking in finance means piling on leverage. In a moral-hazard economy, profits are privatized and losses socialized.

Inside Man, the documentary film by Charles Ferguson that delves deeply into the financial crisis, captures the ethos of a moral-hazard economy. "Fifty-billion-dollar deals were not large enough," said a financier. "So we'd do $100 billion deals."

Many of these leveraged, swing-for-the-fences financiers are still in the game. With the notable exception of Lehman Brothers, the financial firms that took the biggest gambles, pocketed the most money, and made the most catastrophic mistakes were bailed out by taxpayers (although the cost appears to be a lot less than first feared).

Banks Win; You Lose

The same can't be said for workers, homeowners, and savers. Government statisticians reported that in September, 17.1 percent of the civilian labor force—more than 26 million workers—were unemployed or underemployed (i.e., involuntarily working part-time or otherwise marginally attached to the job market). Home prices are down some 30 percent since the mid-2006 peak, and further price declines are likely, with an estimated 3 million more vacant housing units than usual on the market.

Extremely low interest rates have boosted bank finances over the past two years, but they also cut sharply into the returns savers could earn on everything from money market mutual funds to certificates of deposit.

The danger is that bailout is now the basic business plan of finance. "Now look into the future and imagine the next bubble, for we may be confident another bubble will come along unless human nature is totally altered by this experience," wrote the late Peter Bernstein, the dean of finance economists during the fall of 2008. "Why should any CEO bother any longer to calculate risk vs. return in making business decisions? We can put it more strongly: 'Bailout' has become the operative concept of the new world order. As a consequence, the word 'risk' will soon disappear from the vocabulary of business management, at least large-scale business management."

This is an outcome that needs to be averted at all costs. With the breathing space accorded by the stabilization of the financial system, now is the time to put the no-bailout hammer down.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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