Housing Bailout: Crony Capitalism Comes to America?

by: Menzie Chinn

Or, who will be the Keating 5 of the 2000's? Perspectives from those of us who remember the East Asian crises of the 1990's.

From the NYT:

A 'Moral Hazard' for a Housing Bailout: Sorting the Victims From Those Who Volunteered

By EDMUND L. ANDREWS

WASHINGTON -- Over the last two decades, few industries have lobbied more ferociously or effectively than banks to get the government out of its business and to obtain freer rein for "financial innovation."

But as losses from bad mortgages and mortgage-backed securities climb past $200 billion, talk among banking executives for an epic government rescue plan is suddenly coming into fashion.

A confidential proposal that Bank of America circulated to members of Congress this month provides a stunning glimpse of how quickly the industry has reversed its laissez-faire disdain for second-guessing by the government -- now that it is in trouble.

The proposal warns that up to $739 billion in mortgages are at "moderate to high risk" of defaulting over the next five years and that millions of families could lose their homes.

To prevent that, Bank of America suggested creating a Federal Homeowner Preservation Corporation that would buy up billions of dollars in troubled mortgages at a deep discount, forgive debt above the current market value of the homes and use federal loan guarantees to refinance the borrowers at lower rates...

One paragraph in the article I find quite amusing:

Surprisingly, the normally free-market Bush administration has expressed interest. Treasury officials confirmed that several senior officials invited Mr. Taylor to present his ideas to them on Feb. 15. Mr. Taylor said he had also received calls from officials at the Office of Thrift Supervision and the Office of the Comptroller of the Currency, which is part of the Treasury Department.

To me, it is completely unsurprising that the Administration should be willing to bail out financial institutions. They are well connected in the way that the unemployed [1] or the uninsured [2] are not.

However, this is not a rationale for not intervening. As I've said before, "Just say 'no'" is not a viable policy. The key point is to realize that, just like some of the East Asian economies in 1997, we are well past the point about worrying about the impact of current policies on "moral hazard" (see this analysis [pdf]). We needed prudential regulation in the period leading up to the housing boom (sadly, policy makers failed in that respect). That is when contingent liabilities built up (see these posts on "looting" [3], [4]). Now, it is not possible for the government to credibly commit to not intervene, when the financial system's operation is at stake (i.e., as Krugman has said, the horse is out the barn door).

And make no mistake -- the financial system is to some degree already frozen, and there is little prospect for a complete unfreezing of the system without substantial government intervention. From Deutsche Bank Economics/Strategy Weekly (Feb. 22):

...Taking MBS spreads as an example, spreads have now widened beyond the levels reached in the convexity episode of 2003, and is approaching the highs of the LTCM crisis of 1998. We emphasize that it is important for the market not to anticipate the kind of mean reversion that occurred in those previous widening episodes. In 1998, the spread widening wasn't a result of a systemic problem (at least in the principal developed economies), but rather was narrowly addressed with the unwinding of LTCM's positions. Spreads moved back relatively quickly on GSE buying, as GSE’s then were a reasonably large part of the mortgage market at that time, unlike the current moment, when the GSE's have been and are still hampered by regulatory and competitive restrictions, and thus are too small to serve as a stabilizing force.

In this sense, the current crisis is very much like the S&L crisis. And as it looks more and more likely that the government will have to spend billions of dollars bailing out investors, banks, and households, it seems to me that accountability is required. Who in the Administration pushed to prevent regulatory oversight? Who in Congress pushed the interests of the banks?

And we should look very carefully at the proposals that are being pushed by the financial industry, even as we acknowledge that laissez faire is not tenable, and we seek to establish procedures and institutional reforms that will prevent a replay. In particular, thinking about a well-funded, integrated, regulatory system that is insulated from political pressures would be a good place to start.

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