Gov't tries to contain mortgage crisis

[Wanderer]

It would be funny if it weren't serious...

By MARTIN CRUTSINGER, AP Economics Writer 1 hour, 29 minutes ago

WASHINGTON - After a slow and stumbling start, official Washington is scrambling to try to prevent the unfolding mortgage crisis from pushing the country into recession during an election year. There is a strong feeling, though, that the government will need to do more to avert a financial disaster.

One former Treasury secretary advocates temporary tax cuts and emergency spending on the order of $50 billion to $75 billion. Such action could help the U.S. from slipping into what Lawrence Summers, who served under President Clinton, fears could become the worst downturn since the steep 1981-82 recession.

Some Republicans are worried, too.

From both Martin Feldstein, who was President Reagan's top economic adviser, and former Federal Reserve Chairman Alan Greenspan have come calls for deeper government intervention to deal with the threat.

Before it is all over, the government may have to resort to measures last used in the savings and loan crisis of the 1990s. Back then, it was a new agency to take over failing thrifts sunk by bad loans. Today, it could mean a government agency to buy up billions of dollars of mortgage-backed securities that investors are shunning.

The Bush administration thus far has opted for less dramatic measures. In fact, the administration came reluctantly to the biggest step taken to date — the "teaser freezer" announced two weeks ago.

A deal with the mortgage industry will freeze the low introductory "teaser" rates for five years on some subprime mortgages — loans to people with spotty credit histories. The rates were to climb much higher, making the mortgages unaffordable for many people and putting their homes at risk of foreclosure.

The hope is that this agreement will buy time for the housing market to rebound. That would make it easier for these homeowners to refinance to more affordable fixed-rate loans.

But estimates are that only about 250,000 people will end up getting a rate freeze — a fraction of the 3.5 million home loans that could go into default over the next 2 1/2 years.

The administration also is working with Congress to increase the $417,000 cap on the size of loans that the big mortgage companies Fannie Mae and Freddie Mac can handle. This step could help in high-cost housing areas such as California.

In addition, the administration is supporting legislation that would boost aid to lower-income homeowners by increasing the scope of mortgage insurance programs handled by the Federal Housing Administration.

These efforts may help at the margins. They do not, however, address one of the biggest threats to the economy: a spreading credit crisis triggered by the soaring defaults on subprime mortgages.

Some of the biggest names in finance have suffered multibillion-dollar losses as a result, and critical segments of the credit markets have frozen up. Banks and investors fear making further loans or buying securities backed by debt because they do not know how many more loans might go into default.

Ben Bernanke, facing his first major test as Fed chairman, is getting mixed reviews. The Fed was embarrassed when the credit crisis hit in August. That happened only two days after the central bank had decided to keep interest rates unchanged and declared that inflation was a bigger risk than weak economic growth.

The Fed has cut interest rates by a full percentage point since that time. But only the September cut — a bigger-than-expected one-half of a percentage point — elicited cheers on Wall Street. The two quarter-point moves brought about market declines as investors worried the Fed did not recognize the severity of the problem.

The trouble is that the credit crisis is occurring at the same time that a run-up in energy prices is increasing inflationary pressures.

And that is the dilemma.

If the Fed cuts interest rates to keep the economy out of a recession, it could sow the seeds for higher inflation and perhaps give the country the worst of both worlds, bringing back that 1970s bugaboo, "stagflation," in which growth is stagnant and inflation is getting worse.

In a novel approach, the Fed is auctioning off money to the banks in an attempt to get them to open up their loan spigots. The first two auctions, for a total of $40 billion last week, went well. But the amount of the cash provided to the banks paled in comparison with the $500 billion from the European Central Bank.

Many economists believe the Fed will have to cut its federal funds rate, the interest that banks charge each other, at least three more times and strengthen the wording of its statements. In that way, the markets would know the Fed will do whatever is needed to fight economic weakness in spite of its lingering worries about inflation.

"The difference between a soft economy and a recession is confidence. If the Fed appears reticent to do what is needed, like they did at their last meeting, that does not help confidence," says Mark Zandi, chief economist at Moody's Economy.com.

As for the administration and Congress, a tax cut possibly in the form of a rebate probably will be debated in the coming year. President Bush told reporters at the White House on Thursday that "we're constantly analyzing options available to us." He insisted that the economy's underlying fundamentals remained strong.

Summers, however, in a speech last week, urged bolder action. "For the last year, the economic consensus, and the policy actions that have flowed from it, has been consistently behind the curve," he said.

Gaining some currency is the idea of a government agency modeled after the Resolution Trust Corp. of the S&L days that would buy up mortgage-backed securities as a way of dealing with bad loans. About $100 billion in such loans have surfaced and an additional $200 billion are likely, according to market estimates.

If the government spent $150 billion to $200 billion to purchase mortgage-backed securities, the thinking goes, it would prevent a fire-sale that would drive prices of these securities even lower.

When the housing market stabilizes, the price of the government-held securities would begin to rise, allowing the government to sell them back to investors.

Whatever approach the government decides to take, economists said it will take time for the current problems to resolve themselves. They expect this housing downturn, which followed a five-year boom, to last through most of next year even under a best-case scenario in which the country avoids a full-blown recession.

"We have the fundamental problem that we built too many houses and we charged too high a price for them," says David Wyss, chief economist at Standard & Poor's in New York. "We have to stop building houses for a while and the prices have to come down. We are trying to make sure that process doesn't derail the rest of the economy."

___

EDITOR'S NOTE — Martin Crutsinger has covered economic issues for The Associated Press in Washington since 1984.

[FaxModem1]

So, is this thing actually going to solve the problem, or are we talking using the pumps on the Titanic here?

[Darth Wong]

I just saw an infomercial for www.noeviloil.com where the guy claimed that by anointing yourself with the Holy Spirit, you can make those mortgage payments. Clearly, America has developed a real solution for the mortgage crisis.

Sadly, I'm not making that up. That's really what the guy says. He actually calls it "divine transfer", as in "divine transfer of funds".

[Gerald Tarrant]

So, is this thing actually going to solve the problem, or are we talking using the pumps on the Titanic here?

Conventional economic wisdom is predicting a recession. The first predictions I saw weren't based on the mortgage/housing bubbles. They were actually thought to be a result of trade considerations. Krugman and a few others actually think the recession will be the beginning of market mechanisms to effect trade/currency rebalancing. I don't think anybody seriously believes they can stop the recession even with measures like this. Rather their goal seems to be to lessen the depth of the recession, and allow enough credit fluidity for a decent recovery at some point. I.E. no one wants the full effect of the twin shocks of Mortgage crisis and currency re-valuation to appear simultaneously.


As for the bad loans problem itself, The article notes this

If the government spent $150 billion to $200 billion to purchase mortgage-backed securities, the thinking goes, it would prevent a fire-sale that would drive prices of these securities even lower.

the Federal government isn't spending enough money to cover the outstanding debt. They might at some point, but that would require more political will than anyone seems willing to muster.

The article has this to say

Today, it could mean a government agency to buy up billions of dollars of mortgage-backed securities that investors are shunning.

That suggestion looks like some of the problems Japan has been laboring under. Their banks have had loads of bad debt which has kept their growth laggardly.

Editorially: I don't think the scales of the US versus Japanese debt are remotely close, but the preceding suggestion is a bad precedent. Honestly it's bad news to bail out too many of the speculators in this bubble. If the government does that, then financial markets are unlikely to create the internal guidelines that will prevent this sort of overvaluation again, furthermore banks have some incentives to not foreclose on salvageable debtors (foreclosures are a loss for everyone, especially in a weaker housing market). The bailout frees the creditors from needing to renegotiate, or allow alternate payment plans, or figure their way through this with the smallest loss possible.

Some of the losses that are predicted haven't been realized yet. I.E. we have some 3.5 million homes (from the article) that are potentially in default. If the bailout happens the banks wash their hands of the whole affair, and no more negotiation between creditor and debtor goes on. However the banks have a disincentive to foreclose (given the weak housing market they'd might get 50% of their loan recouped). So if things are left alone some banks might negotiate contracts that allow debtors a little more leeway. A bank would weigh its certainty of recouping a much reduced loan value against some chance of recouping a little more. Obviously there would still be a large number of foreclosures of homeowners who were realistically incapable of ever paying off the loan, but the banks have an incentive to work with marginal borrowers in the hopes of recovering more, and maybe making some profit. So for the record I think the bailout is a bad idea. Also I should note that President Bush's current bailout/rate freeze seems too small for the current problem.

[Gustav32Vasa]

One former Treasury secretary advocates temporary tax cuts and emergency spending on the order of $50 billion to $75 billion.

[SirNitram]

See? They literally cannot fathom a solution other than 'CUT TAXS!!!!'.

And what does the solution come down to? Trying to bail out the banks who own all the worthless debt. I wonder if all those municipalities who were told the loan-backed investments they bought were actually stable will get a penny... Nah. Must bail out the banks by giving them even lower interest rates and even more cheap credit. I mean, that got us in, surely we can spend our way out of the recession now.

[J]

Must bail out the banks by giving them even lower interest rates and even more cheap credit. I mean, that got us in, surely we can spend our way out of the recession now.

Hey now, have a little faith in the Free Market, surely it'll create countless billions in wealth and fix everything for us, right?

It's funny in a sad way, one would almost think the government is deliberately trying to ruin the economy.

[Elfdart]

Hey now, have a little faith in the Free Market, surely it'll create countless billions in wealth and fix everything for us, right?

It's funny in a sad way, one would almost think the government is deliberately trying to ruin the economy.

I always thought they wanted to make this country just like Argentina, Paraguay or Chile in the 1970s: a bankrupt police state deep in debt.

[J]

I always thought they wanted to make this country just like Argentina, Paraguay or Chile in the 1970s: a bankrupt police state deep in debt.

You wouldn't happen to own a copy of The Shock Doctrine by Naomi Klein would you?

[SirNitram]

Must bail out the banks by giving them even lower interest rates and even more cheap credit. I mean, that got us in, surely we can spend our way out of the recession now.

Hey now, have a little faith in the Free Market, surely it'll create countless billions in wealth and fix everything for us, right?

It's funny in a sad way, one would almost think the government is deliberately trying to ruin the economy.

I've read Rand. This is all exactly as according to her whacko ideals. But hey, they got someone who loved her work as the Fed for so long, his word became law...

[Uraniun235]

I've read Rand. This is all exactly as according to her whacko ideals. But hey, they got someone who loved her work as the Fed for so long, his word became law...

Oh, I doubt he only loved her work...

[Einhander Sn0m4n]

Must bail out the banks by giving them even lower interest rates and even more cheap credit. I mean, that got us in, surely we can spend our way out of the recession now.

Hey now, have a little faith in the Free Market, surely it'll create countless billions in wealth and fix everything for us, right?

It's funny in a sad way, one would almost think the government is deliberately trying to ruin the economy.

I've read Rand. This is all exactly as according to her whacko ideals. But hey, they got someone who loved her work as the Fed for so long, his word became law...

Are you fucking shitting me!? America's been running its economy like Ayn Fucking Rand!?

This country deserves whatever the fuck it gets. I give up.

[Darth Wong]

Are you fucking shitting me!? America's been running its economy like Ayn Fucking Rand!?

Not exactly. It's been running its economy like an aristocratic kleptocracy. But the right-wingers believe that it should be run according to Ayn Rand's philosophy, and this belief is routinely used in order to justify policies whose true kleptocratic motives would otherwise be quite transparently obvious to the general population.

[Gerald Tarrant]

Must bail out the banks by giving them even lower interest rates and even more cheap credit. I mean, that got us in, surely we can spend our way out of the recession now.

Hey now, have a little faith in the Free Market, surely it'll create countless billions in wealth and fix everything for us, right?

It's funny in a sad way, one would almost think the government is deliberately trying to ruin the economy.

I've read Rand. This is all exactly as according to her whacko ideals. But hey, they got someone who loved her work as the Fed for so long, his word became law...

Um, not so much. Her stated politics were decidedly laissez-faire. Bailouts aren't really in it. Rather, the approach her type would probably propose is more along the lines of letting institutions with bad loans fail or prosper on their own merits, or their own ability to recoup something from their writedowns.

The tax cuts are consistent with Rand's views of Libertarianism, but not for any specific ill. Rather, Laissez-Faire devotees like tax-cuts because it returns the economy to a less government controlled state. Dishonest supply siders will say a tax-cut is a solution to everything. Spending doesn't really figure into supply side thoeries.

One former Treasury secretary advocates temporary tax cuts and emergency spending on the order of $50 billion to $75 billion.

For the record this is completely in keeping with Keynesian methods of dealing with recessions. Apparently despite the supply side preferences of the Administration there are still a few Keynesians in Treasury.

[Edi]

Too bad that it's not going to work if they try that. The state of the US economy is such that they need to cut spending and hike taxes for the richest part of the population if they want to get anything done, as well as reinstate a lot of the controls and regulation on the economy that were put in place after the Great Depression and which have been torn down as part of the Republican agenda of eliminating government.

Tax cuts are only beneficial if taxes are too high to begin with and this is manifestly not the case in the US.

[Gerald Tarrant]

Too bad that it's not going to work if they try that. The state of the US economy is such that they need to cut spending and hike taxes for the richest part of the population if they want to get anything done, as well as reinstate a lot of the controls and regulation on the economy that were put in place after the Great Depression and which have been torn down as part of the Republican agenda of eliminating government.

Tax cuts are only beneficial if taxes are too high to begin with and this is manifestly not the case in the US.

I disagree with the bolded section above. There are two major schools of thought on government intervention.

The Keynesian view is that recessions are primarily due to slumps in demand, according to that viewpoint government can make-up some of the missing demand by spending more in a recession. They can also give taxpayers more money to spend with a tax cut. Consumer preferences are usually expressed as percentages and as an aggregate (i.e. over the entire economy) this is often expressed simplistically as consumption and savings, but more complex models itemize these more carfully. In any case some percentage of the tax cut translates into consumption which boosts demand. So the Keynesian solution is to increase demand by spending money (which translates directly into more consumption and therefore higher demand) and to cut taxes some percentage of which will be consumed and some percentage of which will be saved. Which demographic should get the lion's share of the tax cut depends on their preferences for savings versus consumption. I believe that in the US lower income brackets consume a higher percentage of their income in general. The introductory econ stuff I did on Keynesianism didn't fuss too much about income brackets though.

The second school of thought is Supply Side economics. A rough summary (gleaned from what I remember) follows: The thinking here goes that people work harder if they get paid more. They assume that taxpayers are roughly indifferent between a tax-cut and a pay-raise, i.e. taxpayers treat a tax-cut as a pay-raise. So over the long-term a tax-cut will increase the productivity of the work force.

Most economists belong to one of the two schools of thought above. There are some special cases who take elements from each. But in general the thinking is that one of the above theories describes the way the economic world works, and how to shorten recessions. The current tax rate isn't really relevant to the Keynesian principle which is Tax_Cut_Value * Consumption_Preference = Increase_in_Demand. Supply siders really only address the current rate of taxes when they're talking about the Laffer Curve (addressed below)

Now Supply Side economics has been politicized recently. Reaganomics is a subset of this. What makes Reagonomics unpalatable is some of the distorted claims that were made by his advisors. The most (in)famous of these is the Laffer curve. The idea was based on elementary Calc; the model notes that at 0% and 100% income taxes there is no revenue made by the government. At 0% the government has no share, and at 100% people quit working because they keep nothing (this assumption doesn't take into account government spending or benefits, which is a major flaw). Now since income increases as the tax-rate moves from 0%-1% and decreases as income moves from 99%-100% (again the model assumes that all people quit working once they keep nothing) somewhere between there we ought to find a tax rate which generates maximum income. So far there isn't too much wrong with this, i.e. the assumptions which have been made are a decemt description (for the simplicity of the model) of the way people behave. But the next step is where thinks go all wrong, Rabid Supply Siders claim that the Laffer curve applies to whatever tax-rate we're currently at. It was asserted that Reagan's tax-cuts met the "Laffer standard", the same thing has been stated about Bush's tax cuts. Neither is true. Some cuts do meet this standard, Capital gains cuts sometimes increase revenue above the expected economic growth rate. But, In general Laffer devotees overestimate the elasticity of income (how much people will change their behaviors based on taxes) so they always overstate their case.

[Gerald Tarrant]

edit: I realize my post was a little unclear on the Laffer curve. When I said meet the "Laffer Standard" I meant a tax cut which "pays for itself" or increases economic activity to the point that higher revenues are received in the next tax period. I'm not aware of any US income tax cuts which have recouped the cost of the cut, the theory as it is currently applied is BS. Greg Mankiw, a Harvard economist, at one point called proponents of the Laffer Curve "hacks and cranks", although he withdrew it from later editions of his textbook, since scholarly language is not supposed to be so honest.

[K. A. Pital]

It was asserted that Reagan's tax-cuts met the "Laffer standard", the same thing has been stated about Bush's tax cuts. Neither is true.

Hah. That's just stupid. Tax cuts have recouped the cost? Were that even remotely true, the US policies of cutting taxes and spending in excess would have worked brilliantly, after all the revenue is going up with the spending... but it's not doing that in reality. Morons.

[Gerald Tarrant]

Here's what Dr. Mankiw had to say on the subject

My other work has remained consistent with this view. In a paper on dynamic scoring, written while I was working at the White House, Matthew Weinzierl and I estimated that a broad-based income tax cut (applying to both capital and labor income) would recoup only about a quarter of the lost revenue through supply-side growth effects. For a cut in capital income taxes, the feedback is larger--about 50 percent--but still well under 100 percent. A chapter on dynamic scoring in the 2004 Economic Report of the President says about the the same thing.

Link

So while the tax rates did produce feedback which increased growth, that growth * tax_rate wasn't sufficient to offset the loss from a smaller growth * higher_tax_rate situation.

This is a pretty good summary of the current thinking in economics when it come to the Laffer curve: it hasn't ever really fit actual US tax rates, very few if any Americans find themselves on the wrong side of the Laffer curve.

One more note Link Mankiw's opinion piece in the business section advices that Congress should avoid doing anything about the coming recession and leave it to Monetary policy.