NorCalSavant

Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and FDIC Chair Sheila Bair testified in the House on Tuesday about the credit crisis and the federal response to it especially in light of Troubled Assets Rescue Plan or TARP.

Credit Squeeze, Foreclosures and Recession

The current crisis was an outcome of problems on many economic activity fronts. Its genesis lay in the 2001 recession following the tech bubble burst. The Federal Reserve drastically lowered the interest rates and kept them low for a long time to stimulate the economy. One consequence of this was to make home mortgages cheap over a long period of time sending demand and prices for homes up.

In the go-go years of easy home credit and skyrocketing home prices, Wall Street created new financial products like mortgage-backed securities and credit default swaps to manage the risk of default on these newfangled securities. The mortgages were sold, combined, securitized, diced, and sold again many times on the street. The banks did not have to keep the mortgages they sold to borrowers as much as before because they could easily sell it off in the new financial marketplace. Thus they had little incentive to do due diligence before approving a new mortgage loan. Stated income mortgages, often with a wink and a nod from the underwriters, soared. Many borrowers easily gave in to the temptation to borrow beyond their means simply because they could. Risky subprime mortgages multiplied in this interplay of greed and false assurances of rising home prices on the part of all parties including the lenders and the borrowers.

The credit default swaps which were supposed to act as insurance against defaults were completely unregulated by explicit congressional mandate slipped into legislation without any debate and discussion at the 11th hour into a must pass bill by Republican leadership in the waning days of Bill Clinton’s presidency at the behest of the Wall Street. A company selling an insurance product has to follow strict regulations regarding assets and liabilities. There were no such requirements for these credit default swaps.

When interest rates started to go up, the borrowers began to default on their mortgages. Foreclosures shot up dramatically creating major problems on two fronts. The value of these foreclosed mortgage-backed securities were now worthless or close to it. The institutions holding them were teetering on to insolvency. Risk management via credit default swaps was no use when the time came because of the poor government regulation. Alan Greenspan, a fierce anti-regulation proponent and ex Federal Reserve chairman admitted to a flaw in his anti-regulation ideology or model concerning the credit default swaps in a separate testimony at Congress.

Many banks did fold, and those that did not already fold had little trust in financial transactions with each other, not knowing who could fold next. That, in effect, caused the credit squeeze. The credit squeeze affects all businesses not just financial businesses. Credit is the lubricant that greases the moving parts in the economic engine. The credit squeeze put severe brakes on the economy as a whole, precipitating, deepening and lengthening the recession.

The other thing the foreclosures did was to add to the supply of houses on the market further depressing house prices. The foreclosures are expected to continue into the current future if nothing is done. FDIC chair Sheila Bair estimates up to 5 million foreclosures in the next two years. House prices are therefore expected to stay depressed. It also means a very depressed housing construction industry in the foreseeable future.

Efforts to revive the economic engine to end the recession should include both — relieving the credit squeeze and stopping the foreclosures to the extent possible so that the toxic mortgages can be salvaged to the extent possible and the housing construction industry can be an engine of economic growth again.

Federal Rescue Plan

Hank Paulson has already spent $250 billion on rescuing Wall Street to relieve credit squeeze but practically nothing on reorganizing delinquent mortgages to stop foreclosures, reduce housing supply and spur/boost home prices and housing construction industry. Sheila Bair was the only one among the trio fighting for mortgage readjustment. She estimated the cost of the program to be $25 billion, a mere tenth of what has been spent on big Wall Street firms. Even that relatively inexpensive a measure was not supported by Hank Paulson.

The credit squeeze and the recession problem has to be attacked on both the fronts — Wall Street and Main Street. What do you think? Why is Hank Paulson not doing anything substantial on the home mortgage front?

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