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The Mechanics of the Paulson Rescue Plan

Addressing the Twin Crises: Credit and Solvency

Now that we’ve gotten through an ugly spasm of political theater and legislative sausage-making and enacted the Paulson rescue plan, it’s time to ask whether it’s working, and how we’ll be able to tell.

As I’ve said before, there are two different crises in the financial world. We have an acute credit crisis that directly affects capital markets and is now in the process of creating a serious recession. But we have a longer-term solvency crisis that affects the ability of the financial industry to fund business expansion and consumer spending.

I’ve talked a lot in recent days about the credit crisis, which has now broken through into the media spotlight in a way that suggests it’s at or near its peak. You already know that when you start getting hot stock tips from grocery-store clerks, it’s time to get out of the stock market.

Well, when media types do woman-in-the-street interviews and ask people if they know what LIBOR is, you know it’s time to ask whether the credit crisis may soon abate.

At any rate, I’ll give you a roundup on the current state of credit and capital markets in another post. Today I want to look at the solvency crisis.

The source of all the disorder in the financial world is the loss of value in the housing market, as the bubble deflated. The losses arising from lower home values have to find a place to go, and that is what financial firms are wrestling with.

The Paulson rescue plan as currently enacted is very likely to provide a transmission channel for this financial stress. Whether this was aforethought or an unintended consequence is a question for Paulson and Bernanke. I did have a brief conversation with Congressman Hensarling yesterday, in which he told me that creating unintended consequences is one of the things Congress does best.

So let’s trace this through.

If you bought a house for a $750,000 and it’s now worth more like $650,000, someone has to flush $100,000 down the toilet. Multiply that by millions of houses and you have a sense of the problem. We have to ask who it is that will eat that loss.

Well, who should take the loss? You can argue that it’s the guy who bought more house than he could afford. Or you can say that it’s the bank’s fault for selling cheap mortgages without coherent underwriting standards.

But as interesting and contentious as that question is, it’s beside the point. When you have a problem this big, the pain is never taken by who’s at fault (even if you could clearly establish who that is). The pain will be taken by whoever is in the best position to take it.

That’s the lesson of our political system, which responds to squeaky wheels by creating channels for transmitting stress to less squeaky wheels.

So imagine a woman who bought a house in the last year or two with one of those exotic mortgages, probably with an extremely low LTV, and maybe with interest-rate reset features.

Our heroine has very little incentive to stay in that house. She may owe more on the mortgage than the house is now worth. Even worse, she may be stuck with a monthly payment that is simply beyond her means. And her equity position in the house is little or nothing.

The rational thing for her to do is to walk away.

That leaves the bank with a house that’s worth far less than the amount they put up to fund the mortgage. The homeowner doesn’t really take an inordinate amount of pain. The pain shifts to the bank. Or more precisely, to the investors who own the mortgage-backed securities that take the cash flows from the mortgage.

Those investors are now left with a massive capital loss. And because of that loss, their ability to make new investments is much reduced. Multiplied by millions of investors, that produces a net drag on economic activity throughout the world. There’s just no money to fund business expansion.

(There’s another extremely important structural factor in the diminution of investing power, and that’s de-leveraging. That’s a point for another post.)

At this point, Congress and the FDIC enter the picture. For nearly two years, FDIC chairwoman Sheila Bair has been aggressively saying that we need foreclosure relief. And Congress took this message completely to heart. The Housing Recovery Act passed in July provides up to $300 billion in bailout money for people who can’t pay their mortgages (among other provisions).

But what are we saying when we assume that the most important goal is to prevent foreclosures?

We’re saying that we don’t want homeowners to suffer the consequences of the loss in housing value, whether it’s their fault or not. The ethical question has been completely sidestepped, but forget about that for now. By extension, we’re saying that we don’t really want to let the housing market find its own level.

Chairwoman Bair has been pressing for measures that would encourage or even compel banks to avoid foreclosing on people who can’t pay their mortgages. When she seized IndyMac and became its de facto CEO, she went so far as to suspend all of the foreclosures that the failed bank had in process.

Instead, she wants bankers to reduce the principal amount of loans outstanding to distressed borrowers. For a variety of reasons (some good, some bad), banks are very reluctant to do this, preferring to offer interest-rate reductions.

What happens when you reduce the principal amount of a mortgage to someone who has little or no equity in the home? It’s exactly as if you reduced the price at which the person bought the house.

Foreclosure relief is all about rolling back the worst excesses of the housing bubble, as experienced by the people who were among the last to buy. Again, try to forget about the moral dimensions of this as we follow the analysis.

Even if you shift all of the pain off the homebuyers, it still has to go somewhere. And this is where the just-enacted Paulson rescue plan comes into the picture.

Foreclosure relief through reduction of mortgage principal amounts is probably going to become the government’s favored means of dealing with the housing mess. That means that the value of mortgage-backed securities will tend to fall sharply, as monthly payments from newly-reduced mortgages fall.

But wait! These are the same securities that are currently unmarketable, because the prices that buyers are willing to pay are far below what sellers are willing to accept.

And they’re the same securities that the Treasury will now have up to $700 billion to buy.

What’s the valuation at which those securities will be purchased? That’s a marvelous question. It’s widely agreed that the prices need to be set somewhat above the current market values. Otherwise you don’t do anything to address the solvency problem faced by banks and Wall Street firms.

And voila. We’ve just created a channel through which the pain of housing overvaluation will be transmitted to the taxpayers as a whole.

If FDIC and Congress follows through on their plans to induce banks and other intermediaries to reduce the principal amounts of a great many mortgages, the reduced cash flows will directly impact the value of MBS that will be purchased by the Treasury.

This is a directly inflationary outcome. Is that a bad thing? That’s another complicated question. The answer is not necessarily yes, especially compared with the alternatives.

But how do you deal with the overwhelming moral hazard that you create by giving a mulligan to everyone who paid too much for her house? At least some of these people will learn that if you play dirty, you’ll win because the suckers who play by the rules will bail you out.

There’s one and only one way to deal with moral hazard created by government. And that’s with a massive clampdown by government itself on free-market activity.

And this part of the picture is already in place.

The broad effect of the Fannie Mae/Freddie Mac takeover is to impose a price control on the entire housing market.

What the heck does that mean? It means that the mortgage business has now been almost 100% nationalized. Debt issued by Fannie and Freddie is now explicitly guaranteed by the government, so any conforming mortgage will almost automatically be funded by Fannie and Freddie.

This is the reality of the housing market today. People with good credit and good down payments will generally have no trouble buying houses, as long as they are priced below the Fannie/Freddie conformance limit.

Everyone else will have a very, very hard time getting a mortgage, and the prices for those mortgages will be exorbitant.

In this way, the government has made it all-but-impossible for home values to ever rise very high again. And that takes care of your moral hazard, big-government style.

-Francis Cianfrocca

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