Friday, August 17, 2007

Workouts, Not Bailouts

Op-Ed Columnist
The New York Times
August 17, 2007

In April, Henry Paulson, the Treasury secretary, declared that all the signs he saw indicated that the housing market was “at or near the bottom.” Earlier this month he was still insisting that problems caused by the meltdown in the market for subprime mortgages were “largely contained.”

But the time for denial is past.

According to data released yesterday, both housing starts and applications for building permits have fallen to their lowest levels in a decade, showing that home construction is still in free fall. And if historical relationships are any guide, home prices are still way too high. The housing slump will probably be with us for years, not months.

Meanwhile, it’s becoming clear that the mortgage problem is anything but contained. For one thing, it’s not confined to subprime mortgages, which are loans to people who don’t satisfy the standard financial criteria. There are also growing problems in so-called Alt-A mortgages (don’t ask), which are another 20 percent of the mortgage market. Problems are starting to appear in prime loans, too — all of which is what you would expect given the depth of the housing slump.

Many on Wall Street are clamoring for a bailout — for Fannie Mae or the Federal Reserve or someone to step in and buy mortgage-backed securities from troubled hedge funds. But that would be like having the taxpayers bail out Enron or WorldCom when they went bust — it would be saving bad actors from the consequences of their misdeeds.

For it is becoming increasingly clear that the real-estate bubble of recent years, like the stock bubble of the late 1990s, both caused and was fed by widespread malfeasance. Rating agencies like Moody’s Investors Service, which get paid a lot of money for rating mortgage-backed securities, seem to have played a similar role to that played by complaisant accountants in the corporate scandals of a few years ago. In the ’90s, accountants certified dubious earning statements; in this decade, rating agencies declared dubious mortgage-backed securities to be highest-quality, AAA assets.

Yet our desire to avoid letting bad actors off the hook shouldn’t prevent us from doing the right thing, both morally and in economic terms, for borrowers who were victims of the bubble.

Most of the proposals I’ve seen for dealing with the problems of subprime borrowers are of the locking-the-barn-door-after-the-horse-is-gone variety: they would curb abusive lending practices — which would have been very useful three years ago — but they wouldn’t help much now. What we need at this point is a policy to deal with the consequences of the housing bust.

Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, as Gretchen Morgenson recently pointed out in The Times, the bank that made the loan would often have been willing to offer a workout, modifying the loan’s terms to make it affordable, because what the borrower was able to pay would be worth more to the bank than its incurring the costs of foreclosure and trying to resell the home. That would have been especially likely in the face of a depressed housing market.

Today, however, the mortgage broker who made the loan is usually, as Ms. Morgenson says, “the first link in a financial merry-go-round.” The mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets that Moody’s or Standard & Poor’s were willing to classify as AAA. And the result is that there’s nobody to deal with.

This looks to me like a clear case for government intervention: there’s a serious market failure, and fixing that failure could greatly help thousands, maybe hundreds of thousands, of Americans. The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts.

And we’ve done this sort of thing before — for third-world countries, not for U.S. citizens. The Latin American debt crisis of the 1980s was brought to an end by so-called Brady deals, in which creditors were corralled into reducing the countries’ debt burdens to manageable levels. Both the debtors, who escaped the shadow of default, and the creditors, who got most of their money, benefited.

The mechanics of a domestic version would need a lot of work, from lawyers as well as financial experts. My guess is that it would involve federal agencies buying mortgages — not the securities conjured up from these mortgages, but the original loans — at a steep discount, then renegotiating the terms. But I’m happy to listen to better ideas.

The point, however, is that doing nothing isn’t the only alternative to letting the parties who got us into this mess off the hook. Say no to bailouts — but let’s help borrowers work things out.


Anonymous Anonymous said...

Well, I agree and disagree with Mr. Krugman. At the end of the day, all investments carry a certain measure of risk. The fact that some investors didn't do their due diligence shouldn't be a reason for the government to bail them out. This should be yet another lesson for investors to closely look at what it is they are buying. Caveat Emptor it's called. During the boom boom tech years, many technology companies were developing vaporware while their stocks carried happy "buy" ratings from investment houses across the board. Look at how that one turned out. One hopes that once investors are burned, hard, they might demand better service from rating organizations in the future and that those organizations also look inwards and reward and reprimand those analysts and fund managers based on the results of their work. In short, people need to learn that their actions carry consequences and if the government steps in at every turn to bail out folks from their own stupidity, it just creates a Pavlovian reaction in people enforcing further irrational behavior because people become accustomed to the Government insulating them from bad decisions. Government's role should be to facilitate the market in making market-based rational decisions, not to blur the risk-reward line from those who make bad decisions.

Where I take some reservation with Mr. Krugman's solution has to do with the individual work-out solution. True, there was indeed much malfeasance on the part of mortgage brokers, underwriters, hedge fund managers and other links in the chain which hauled the resultant packaged securities to the trading market. However, there was also much malfeasance on the part of those who received the loans as well. It's been well documented that many applicants grossly embellished (ok, lied) when it came to reporting material facts related to their creditworthiness, some even going as far as using websites who provided fake pay stubs and employment verification. While it would be wrong to bail out irresponsible hedge fund managers, by the same token it would be irresponsible to reward those either knowingly provided false information on their liar loans or went along with a broker's "creative" statement of their income, to receive a loan which they obviously could not afford the payments for in the long run.

2:55 AM  

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