Morgan Stanley: The Credit Crisis and the Case for Unconventional Solutions

There is increasing support for the use of unconventional tools to fix the current credit crisis, writes Richard Berner in Morgan Stanley's latest Global Economic Forum, referring to the direct assistance to help struggling homeowners, dislocated markets and financial institutions. The use of such tools is clearly a case of crossing the Rubicon for policymakers, but Berner argues that such a step is justified.

Without such action, the credit crisis could take years to unravel, and the cost over time could be enormous:

We estimate that US losses in mortgage lending will run at least $400 billion over the next two years (see David Greenlaw et al., Leveraged Losses: Lessons from the Mortgage Market Meltdown, US Monetary Policy Forum Conference, February 29, 2008). A guess at overall credit losses might put them at $750 billion. Our large-cap banks analyst Betsy Graseck estimates that the yield curve from Fed funds to 10-year Treasury notes would have to persist at 275 bp for two years to increase net interest margins by enough to offset such losses (see Looking for a Bottom in Financials, March 18, 2008).

With respect to the conventional means, Berner notes that the Fed is reluctant to take interest rates significantly lower, and that traditional fiscal policy would only "indirectly cushion the fallout from the housing downturn and the credit crunch." Furthermore in the past two weeks alone, the political climate has changed sufficiently to support more aggressive initiatives, and the Fed's involvement in orchestrating the Bear Stearns sale has now rendered it more difficult to argue against similar assistance for struggling homeowners.

The aid program could take several guises: Fannie Mae (FNM) and Freddie Mac (FRE) recently had their capital surcharge reduced to 20% by OFHEO, and a proposed FHA Housing Stabilization and Homeownership Retention Act would help borrowers refinance into federally insured FHA loans:

Under this proposal, the FHA would provide up to $300 billion in new guarantees that would help at-risk borrowers to refinance with FHA-insured mortgages. Lenders would be required to take a partial loss on troubled loans, and distressed borrowers could refinance the remainder (the fair market value). The FHA would also get a warrant or a soft second lien that would be redeemed if the house were sold at a higher price. The Office of Thrift Supervision has a similar proposal, further allowing the warrants, called “negative amortization certificates,” to trade publicly. [House Financial Services Chairman Barney] Frank also proposes giving $10 billion in community development block grants to the states to purchase foreclosed properties and rent them to previous owners. Guaranteeing loans carries significant risk to the taxpayer, even with a government equity participation in the property. In any case, it seems likely that the Congress will pass, and the Administration will sign, legislation containing some of these elements in the next few months.

Clearly there is a moral hazard in all these proposed actions. Berner addresses the problem:

In considering such risks, officials must weigh two economic arguments: First, in a crisis, while monetary policy can be changed instantly, it may be less effective than a direct solution. Second, once past political and implementation hurdles, direct solutions can take effect quickly, and speed is of the essence to mitigate the ‘adverse feedback loop’ and spillovers to the rest of the economy a crunch will nurture.

In the future, the regulatory bodies will have to adapt for, as Berner notes, re-regulation of the financial markets always follows a crisis. The outcome, according to Morgan Stanley, will be more uniformity of regulation and a safer, better-capitalized financial system. Furthermore:

Intermediaries with little to no regulation will get new oversight, new disclosure responsibilities, and new capital requirements. And America’s patchwork regulatory system will likely get an overhaul. Fed Vice-Chairman Kohn summarizes the future regulatory backdrop succinctly: “A number of markets will need to make institutional changes before they are likely to function smoothly again, and regulators will need to adapt their oversight to take account of the lessons learned. In the end, we will have a safer system, but one with more bank intermediation, less leverage, and higher financing costs for many borrowers” (The U.S. Economy and Monetary Policy, February 26, 2008).

Comments

[nibbs17:]

Mark to market is an estimate that should be tabled and revised. More government 'help' solutions means fewer buyers are responsible for their monetary actions. It won't be long before 300 million Americans adopt an 'we are owed' attitude, therefore bail us out, politicians.

2008 Mar 27 05:26 PM

[LindenMore:]

Here is another interesting unconventional solution to the credit crisis: people lending money to each other directly without intermediaries. I found out about it on change.org:

www.change.org/ideas/v...

2008 Dec 30 04:08 PM