Tame the Global Liquidity Crisis: Congress Needs to Help Central Banks
This morning central banks around the global agreed to intervene in world credit markets to head off rising fears that a severe global lending crunch spawned by the U.S. housing crisis would spiral into a general financial liquidity crisis. The coordinated action by the Federal Reserve, the Bank of England, the European Central Bank, and the Swiss National Bank to offer to lend hundreds of billions of dollars to financial institutions in exchange for collateral that includes mortgage-backed securities shows just how dire are the affects of the U.S. housing market crisis on global debt markets.
But central bankers cannot tackle this problem by themselves over the long haul. Neither repeated interest rate cuts nor successive intervention in global financial markets is going to solve the root problems—too many U.S. homeowners facing foreclosure and too many of their neighbors potentially lining up behind them. To cope with the foreclosure crisis, the U.S. Congress needs to enact legislation that will help responsible homeowners refinance their mortgages at reasonable rates, which in turn will enable the global marketplace for mortgage-backed securities to find its footing and begin to price these tradable securities at realistic values.
The successive shocks to global financial markets and the subsequent attempts by central bankers to cope with the stress are as complex as they are intertwined. Investors in mortgage-backed securities, having discovered belatedly that past performance of these assets is not necessarily a good measure of current risk, have lost confidence in their ability to evaluate all sorts of debt-based assets. Capital is therefore sitting on the sidelines, seizing up credit markets that normally grease much of the U.S. and global economy.
Goldman Sachs & Co. estimates that investor losses of at least $400 billion to date in turn will trigger at least a $2 trillion contraction in credit by highly leveraged financial institutions around the world. The credit contraction alone will cut at least 1.3 percent points from GDP growth, in addition to slowdown in growth from loss of household wealth, loss of consumer confidence, and multiplier effects on consumption demand through the labor market.
This crisis in confidence and liquidity coupled with escalating foreclosures are likely to drive over-corrective declines in home and asset prices. Only by removing the sick assets and restructuring them into healthier assets can the effect of necessary investor losses on the overall economy be limited. Traditional capital markets policy tools are not effective in these conditions. Lower interest rates and even innovative steps by the Federal Reserve to provide a temporary increase in liquidity are not effective in a credit crisis that stems from collapsing confidence about credit quality, combined with accounting requirements that require institutions to mark-to-market asset values.
The U.S. economy teeters on the edge of recession because of a vicious downward spiral in housing prices, escalating foreclosures, and rising losses on mortgage-backed securities—all amid growing numbers of homeowners who have mortgages more costly than their homes are worth. If prices fall another 15 percent, which some analysts are now predicting, then one-third of all mortgages would face negative equity. That realization is what now spooks global financial markets, which are justifiably concerned that they don’t know which financial institutions will suffer perhaps unsustainable losses as a result. And there is reason to worry.
- The number of properties entering foreclosure in the fourth quarter of 2007 set a record, with 7.9 percent of all loans now delinquent or in foreclosure.
- A housing market correction after unprecedented price appreciation is appropriate, and people should not be protected from unwise speculation, yet a panicked freefall not supported by economic fundamentals is bad for the economy.
- We are facing the prospects of a long, severe credit crisis and economic stagnation.
- Monetary and fiscal policy alone will not resolve the crisis.
As the housing bubble bursts, it is clear that the marketplace cannot resolve this crisis on its own. For almost a year the complex legal entities that hold these mortgages have failed to slow the pace of foreclosures—despite exhortations by the Bush administration for mortgage servicers, lenders, and investors to provide voluntary relief. Foreclosure action was taken on almost 1 million properties in the second half of 2007, with more in the fourth quarter of last year than in the previous quarter, notwithstanding efforts by the Bush administration-led voluntary HOPE NOW Alliance of mortgage lenders and investors to curtail foreclosures.
The result: An inability to value underlying mortgage and other assets has been a major contributor to a worldwide credit market freeze. If policymakers do not facilitate the restructuring of millions of at-risk mortgages in private hands quickly, on responsible and sustainable terms, then U.S. policymakers may soon face widespread international pleas for more dramatic steps, including direct government control of distressed mortgage assets. More broadly, and more importantly to average American families, concentrations of foreclosures lead rapidly to neighborhood decline and lost equity for surrounding homeowners—even those who are making timely payments on prime mortgage loans.
The current credit crunch and a looming recession will mean economic pain throughout the U.S. economy. Lost equity spurs more defaults as borrowers under stress conclude that they cannot continue making mortgage payments with no prospect of retaining equity in their homes. And since housing equity and home mortgage debt have spurred economic growth, tightened credit and evaporating equity will continue to chill consumer demand, slowing the economy and resulting in job losses—just as inflationary pressures are appearing.
The unprecedented decline in house prices threatens the financial stability of states and localities, too. Foreclosed, vacant, and abandoned properties attract crime and vandalism, requiring municipalities to shift resources away from other local priorities. Heightened demand for government services comes as revenues, tied to property taxes, decline.
Fortunately, Congress is preparing to act, and act swiftly, on these sets of problems in the U.S. housing market. The Center for American Progress is part of the effort, having put forward two key proposals that Congress is now preparing to debate. The first is our Saving America’s Family Equity, or SAFE plan. The overarching goal of SAFE is to transfer large numbers of existing loans from the current holder of the mortgages—who is faced with a variety of uncertainties and conflicting interests—to new owners who will refinance them on affordable terms.
The sale price paid would reflect the current value of those mortgages, significantly less than the face value. This “haircut” will ensure there is no bailout of the financial institutions and existing investors, many of whom uncritically and irresponsibly created the bubble by lending in the hope that continued house price appreciation would make up for the absence of meaningful credit evaluation.
The resulting transfer will help to unfreeze financial markets. Current investors will exchange the mortgage-backed securities they hold whose value is uncertain for the liquidity and reduced market risk of Treasury securities or cash. Our SAFE program also includes complementary policies, such as housing counselors to homeowners to restructure their mortgages, and new federally backed and responsible loan products, including credit enhancements for new SAFE loans to owner-occupants, which would include more flexible Federal Housing Administration-insured loans as well as special programs for Fannie Mae and Freddie Mac.
A market mechanism to prevent borrowers from getting a windfall is also part of our SAFE plan. Any loan that is written down to below current fair market value of the home could be accompanied by a “soft” second mortgage that permits the lender to recover an amount up to the difference between loan amount and current value, if the home is subsequently sold for more than the new loan amount. A shared-equity instrument would enable the owner, funder, and insurer of the loans to share in home price appreciation up to the original loan balance.
Our second proposal is our Great American Dream Neighborhood Stabilization, or GARDNS plan. Our GARDNS Fund would provide state and local governments with up to $20 billion in new Community Development Block Grants or HOME funds for programs to return foreclosed properties to productive use. Funds would be targeted at communities most heavily impacted by foreclosures, and the funds would be used to purchase bank-owned properties at a discount which would be rehabilitated and then sold or rented affordably.
Each community’s situation will dictate a different mix of strategies. Putting families into homes with payments they can sustain will not only provide a new source of affordable housing and prevent crime and blight; the GARDNS program will reduce housing inventories and keep surrounding house prices from falling further.
Components of both our SAFE and GARDNS plans are included in a number of legislative efforts on Capitol Hill to act swiftly on the U.S. housing crisis. Today’s action by the world’s top central banks shows that U.S. policymakers need to act as quickly as possible.
Andrew Jakobovics is Associate Director of the Economic Mobility Program at the Center for American Progress.
For more information about the Center for American Progress’ policies on the housing crisis, see:
- Strengthening Our Economy: Foreclosure Prevention and Neighborhood Preservation
- Addressing Foreclosures: A Great American Dream Neighborhood Stabilization Plan
- A Practical and Progressive Economic Stimulus and Recovery Plan