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Friday, August 17, 2007

Krugman: Workouts, Not Bailouts

by Calculated Risk on 8/17/2007 04:08:00 PM

From Paul Krugman: Workouts, Not Bailouts. Excerpts are from Economist's View.

... 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. ... 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.
And Krugman argues for workouts, not bailouts:
Consider a borrower who can’t meet his or her mortgage payments and is facing foreclosure. In the past, ... 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 was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets ... And the result is that there’s nobody to deal with.
The federal government shouldn’t be providing bailouts, but it should be helping to arrange workouts. ... Say no to bailouts — but let’s help borrowers work things out.
Tanta has written about the servicer issues. For an overview of how servicing works, see: Mortgage Servicing.

Tanta also wrote about some of the servicer vs. investor conflicts in SFAS 140: Like A Bridge Over Troubled Bong Water. Tanta concluded:
The time to have gotten fired up about the real issues around off balance sheet securitization--the great "de-linking" of risk that was openly advertised as the benefit to the investor of all of this--was back when those 2/28s were being originated. We here at Calculated Risk were on it back then, and being dismissed as "bubbleheads." Absolutely nobody, as far as I know, is happy with any of the bad choices we now have since we've gone into cleanup mode. But this desperate attempt to keep the moral hazard in place, whether it's Cramer begging for a rate cut or bond investors demanding that FASB shoot the wounded, sink the lifeboats, and close the gates of mercy to protect the interests of the AAA crowd, is a little hard to take.

Sit down, boys and girls. There has always been an "information asymmetry" issue with mortgage-backeds. The originator has always known more than you know. The servicer has always known more than you know. The auditors have always known more about the balance sheet ingredients than you have. This problem did not arise a couple of months ago when the ABX tanked.

It has also always been the case that the party on the other side of that cash-flow is Joe and Jane Homeowner. Taxpayer, voter, citizen, parent, child, grannie and gramps, your neighbor. This is a group of folks it's a bit hard to demonize. We've been trying, with this "it's all subprime and all subprime borrowers are deadbeats" meme, but except for a few dead-ender holdouts, that dog is no longer barking. No one will be less surprised than I to find many politicians doing the wrong thing here, out of a misguided sense that something must be done, and seen to be done. Possibly someone will do something sane and useful.
Perhaps Krugman is proposing something 'sane and useful'.

UPDATE: Here is an example of bad ideas from Senator Schumer yesterday.
Senator Charles E. Schumer today renewed his call on the Bush administration to immediately lift the portfolio cap on Fannie Mae and Freddie Mac to help ease the liquidity concerns in the mortgage markets. Schumer added that if Fannie and Freddie’s regulator doesn’t act soon to temporarily allow the companies to provide more liquidity, he will introduce legislation to do so as soon as Congress reconvenes in early September.