This century’s first “Black Monday” on Wall Street is, in certain ways, comparable to the 20th century’s signature day in financial history back in the Fall of 1929. While the one-day losses in 1929 were triple Monday’s decline, then as now the utter failure of a conservative administration to police the financial markets in the Roaring Twenties led to excessive debt and financial speculation followed by the stock market crash of 1929. Then as now, the Hoover administration and the Bush administration pushed for less and less supervision of our financial services industry—with the same results.
We won’t know how similar the two stock market drops may be for several weeks or months, or if the failures of large, heavily intertwined institutions reflect a working through or are the triggers of a contagion. U.S. financial institutions alone have $550 billion in debt maturing this month, which will have to be refinanced amid the sharpest spike yet in the credit crisis. Over the next 15 months, close to a trillion dollars in medium-term floating rate debt owed by financial institutions worldwide must be refinanced. How will these institutions lend to companies when it will be hard for even them to borrow?
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke need to face squarely the vast array of mistakes made by the Bush administration’s financial regulators over the past eight years. When the U.S. housing market slide that began in late 2007 began to gain speed, the Center for American Progress made the point again and again that home prices would not recover until the federal government intervened in a more robust fashion to help individual homeowners cope with the cascading crisis.
At the time, we proposed a series of measures that would have allowed home mortgage borrowers, lenders, and investors to work out payment problems with the help of federal supervision. Instead, the Bush administration embraced Paulson’s voluntary debt workout plan, called Hope Now, which (let’s be frank) failed to help homeowners or the larger home mortgage marketplace. The proof came in March, when Wall Street investment bank Bear Stearns Cos. collapsed into the arms of J.P. Morgan Chase & Co. after the Federal Reserve agreed to lend JP Morgan $29 billion of taxpayer money to cover the risk of buying all of Bear’s toxic mortgage-backed securities.
Instead of decisive action since then, the Bush administration’s voluntary, tepid response to the housing crisis continued, leading to the bankruptcy of another of Wall Street’s “bulge bracket” investment banks, Lehman Brothers Holdings Inc., and the firesale of its larger rival, Merrill Lynch & Co., to Bank of America. Last night’s $85 billion bailout of insurance giant American International Group Inc. puts its broad exposure in the completely unsupervised trillion-dollar credit default swap market squarely on taxpayers’ shoulders. We’re rapidly running out of adjectives to plug into the phrase “too ______ to fail” to decipher the criteria being used to guide the administration’s actions.
Cutting to the heart of the crisis, conservatives’ laissez faire policies left the mortgage finance market and its secondary markets largely unregulated. Hugely flawed subprime mortgage products that bore no resemblance to borrowers’ capacity to repay were allowed to be originated and then packaged and repackaged for sale to investors. This situation was allowed to fester for six years after concerns with subprime lending were first raised.
The actions taken (and not taken) over the past few days attest to the administration’s continuing focus on Wall Street, not Main Street. Despite being in charge for seven and a half years, Bush administration regulators neither recognize how the current turmoil could have been avoided with more effective supervision of the financial markets nor understand how the resolution of this crisis begins with individual homeowners.
Part of the solution lies in the recognition that no amount of packaging and repackaging or buying and selling of mortgage-backed securities and their derivatives will unwind the crisis. Instead of focusing on mortgage-backed securities, action must be taken to modify or refinance the underlying loans that are already in default or will soon be. MBS portfolios are selling at far steeper discounts than the value of the underlying properties because nobody knows how to price mortgage risk appropriately. If the underlying troubled mortgages were extinguished and replaced by loans underwritten to sustainable standards, both homeowners and the capital markets would benefit.
While securitization adds complexity to the question of where the authority to modify loans lies, we believe that recent actions by the Federal Deposit Insurance Corporation to engage in wholesale loan modifications for bankrupt California lender IndyMac Bank’s loans—which it now holds directly or in a servicing portfolio—serve as guidance for where U.S. mortgage giants Fannie Mae and Freddie Mac and the private mortgage servicing companies must go.
The housing bill that recently passed into law mandates a Treasury study of auctions of mortgage pools based on the Center for American Progress’s Saving America’s Family Equity, or SAFE loan program, to get large numbers of loans into the hands of new investors who could restructure the existing loans so that they would perform. Under the SAFE loan program, the discount below face paid at the auction would allow the new note holders to do the necessary writedowns without incurring losses.
The SAFE loan program, like the FDIC actions, recognize that both borrowers and investors, and ultimately taxpayers, are better off when loans are restructured rather than allowed to proceed to foreclosure. Liquidity will return to Wall Street when the confidence in Main Street’s ability to pay its mortgages is restored. The Bush administration should accelerate that study so that U.S. financial regulators can get down to the real business at hand—finally fixing the problem in the mortgage marketplace at its source.
Andrew Jakabovics is the Associate Director for the Economic Mobility Program at the Center for American Progress.