BusinessWeek Logo
Cover Story March 13, 2008, 5:00PM EST

Recession Time

(page 3 of 3)

But the dysfunctional nature of the credit markets, particularly housing assets, I think is overwhelmingly important," says Martin Feldstein, a Harvard University economist who was President Ronald Reagan's chief economic adviser.

But one person's "necessary intervention" is another's "outrageous bailout." When the government steps in, that's when the battle starts about who wins and who loses. Home mortgages account for 44% of private nonfinancial debt, making them one of the main pillars of the debt market. If the value of household real estate falls by 25%—an amount many economists consider plausible—it would be a $5 trillion loss of wealth. Any type of government bailout plan will alter the eventual distribution of losses between homeowners and investors.

BAILOUTS: CHOOSE A BUCKET

The purest form of bailing out homeowners would be forcing lenders to reduce the amounts borrowers owe. Such a "cramdown" could be accomplished by legislative fiat or, more likely, by changing the federal bankruptcy law to allow judges to reduce mortgage debt in a Chapter 13 reorganization the same way they're allowed to reduce other debts. Bills to change the bankruptcy law have stalled in Congress but could gain traction if foreclosures keep rising.

The downside: In the short run, lenders might face even bigger losses. In the long run, they would charge higher interest rates for fear of future cramdowns. And Keith Hennessey, director of President Bush's National Economic Council, said in a Feb. 29 press breakfast that "injecting government through the courts into preexisting contracts" will drag out the housing bust by slowing the debt-adjustment process.

At the other extreme are ideas that would bail out the lenders without trying to prop up prices. Harvard's Feldstein, who publicized his plan in a Wall Street Journal op-ed piece on Mar. 7, would have the federal government make low-cost personal loans to families equaling 20% of their mortgage debt. The homeowners who took the offer would have to use all of the money to pay down their mortgages. That would give a huge shot of cash to lenders and would reduce the likelihood that borrowers would walk away from their homes since the remaining mortgage debt would be well under the home's value. But it would expose taxpayers to risk while doing nothing to reduce the total indebtedness of households. And by letting lenders off easy, it would embolden them to think they could lend irresponsibly again with impunity.

"GOVERNMENT CAN AND SHOULD DO MORE"

Discouraging, huh? "Many people have struggled over the last six months to find effective forms of government intervention and have been disappointed by the paucity of good options," says Douglas W. Elmendorf, a senior fellow at the Brookings Institution. Still, he says: "I think the government can and should do more." He favors bankruptcy reform that would help reduce homeowners' debts along with measures that would help the financial sector by buying up some loans with government money, albeit at a discount.

In the Presidential race, Republican Senator John McCain doesn't want to bail out either side, favoring private workouts between borrowers and lenders. Here's how he summed up his feelings on Mar.11: "It is not the government's role to bail out investors...or lending institutions who didn't do their job." Democratic Senators Barack Obama and Hillary Clinton both tilt toward homeowners, but Clinton is more aggressive, calling for a voluntary 5-year freeze on subprime mortgage rates and a 90-day moratorium on foreclosures.

One idea that's gaining support from some liberals and conservatives alike is the creation of a modern-day version of the Home Owners' Loan Corp., a Depression-era agency that bought mortgages at a discount and issued new, more affordable ones. Alex J. Pollock, a resident scholar at the American Enterprise Institute in Washington, says such an agency would help "avoid a serious downside overshoot where you get a self-reinforcing cycle of defaults, credit contraction, and falling home prices." But Hennessey, the Bush adviser, likens the idea to a teacher who gives her class extra time on an assignment because someone isn't done: "The students who stayed up all night to finish the assignment are in fact quite upset."

Even if the warring parties agreed to such a plan, there would still be plenty of scope for conflict. Lenders and owners of mortgage-backed securities would seek to get as close as possible to 100 cents on the dollar for their loans, while borrowers and taxpayers would want a big discount so the new mortgages would be comfortably smaller than the homes' values. Each side, naturally, would cloak its arguments in the public interest. Lenders would try to dump the worst-performing loans on the government and retain the healthy ones, notes Elmendorf. And any wide-ranging program would inevitably help many undeserving borrowers and lenders.

One danger is that political brawling will lead the debate away from what's best for the economy as a whole. There are many ways to get this wrong. In Japan in the 1990s, for example, insolvent but politically powerful companies got their banks to keep them alive with low-cost loans, which meant that the banks had no money left over to fund new businesses. That led to Japan's infamous Lost Decade of slow growth.

All that said, some inefficiency and political conflict may be an acceptable price to pay for programs that lessen the very real risk of a systemic financial meltdown.

With Jane Sasseen in Washington

Reader Discussion

 

BW Mall - Sponsored Links