Slouching Towards Solvency

President Obama has worked wonders with the budgetary part of the recovery program. But if he doesn't solve the banking and housing crises, the economy will continue collapsing. The latest programs from Treasury Secretary Timothy Geithner are both implausible and impolitic. Geithner's "public-private partnership" to jump-start bank lending would invite the same high rollers who caused the collapse to speculate in securitized bonds, this time with guarantees from the Federal Reserve. Supposedly, once these buyers appear, banks will resume normal lending. If the securities turn out to be worth something, the hedge funds and private-equity investors gain. If the investments go bad, the taxpayers lose. But that's not even the worst part.

This trillion-dollar scheme pays dearly to fetch buyers for newly issued bonds -- but doesn't create a market to help the banks unload the older toxic bonds issued during the bubble years. However, these older bonds are precisely the ones clogging bank balance sheets. If Geithner's plan doesn't address that part of the problem, it won't get the banking system functioning normally.

Meanwhile, the new $75 billion mortgage-relief plan is almost as flawed as the banking rescue. People are denied help if they've been late on even one monthly payment in the past year. But it is these struggling borrowers who need the most urgent help.

The plan permits refinancing, if the new mortgage can be brought down to 105 percent of the current depressed value of the house (thus excluding much of the Sunbelt where mortgages are typically much further underwater). Banks can try to negotiate workouts to reduce the principal value of the mortgage, but if the loan has been securitized, they must persuade the bondholder to eat the loss. The plan is designed primarily for loans held by banks, while most of the troubled mortgages are the "securitized" ones.

At the heart of this entire mess is the system of securitization, which dates only to the 1970s. In principle, it usefully allowed banks to sell off loans and thereby replenish cash to make other loans. But in practice, the system turned into an unsupervised doomsday machine. Not only did the system invite lenders to relax underwriting standards because some sucker down the line was absorbing the risk; more seriously it led to an aftermath that has proven impossible to unwind without having government temporarily take the big banks into receivership to sort out what's really on their books. This remedy is what Geithner hopes to avoid, thus prolonging the agony.

Rather, like Paulson before him, Geithner keeps pursuing more securitization, with the same futile results. Having speculators do the job cannot be done except at an unacceptably high price to taxpayers, with the added cost of inviting a new round of excess leverage and risk.

The refinancing of distressed mortgages, likewise, can only be done efficiently and quickly if government does it directly. This is what Franklin Roosevelt did with the Home Owners Loan Corporation. The seemingly insoluble problem of turning currently worthless mortgage-backed bonds back into loans can be solved using the government's power of eminent domain. Government could then compensate bondholders at so many cents on the dollar.

Recently, economist Alan Blinder, a former vice chairman of the Federal Reserve and occasional contributor to these pages, told The Wall Street Journal, "There has been somewhat of a collapse of the banking system, but an almost total collapse of the shadow banking system. Given our reliance on the latter, we need to get the shadow banking system revived." Ordinarily, I find Blinder a thoughtful and public-minded economist. But this view has it exactly backward.

The real challenge is to minimize the role of exotic securitization and to subject the shadow banking system to full regulatory scrutiny. Somehow, before 1975 businesses got ample credit, homeowners received mortgages, and entrepreneurs were hooked up with investors -- all without securitization. If there is a legitimate but limited role for turning loans into bonds, capital reserve requirements, disclosures, and greater scrutiny are all indicated. Geithner plans none of this.

Recently I interviewed the former governor of the Bank of India, Dr. Yaga Reddy, on how the Indian banking system, and by extension the Indian economy, has avoided catastrophe. India projects growth of about 7 percent in 2009, The New York Times recently reported. In the last quarter of 2008, India grew at 5.3 percent compared to a decline of 6.2 percent for the U.S. How did India dodge the financial bullet?

"We are a poor developing nation," Dr. Reddy explained. "We don't really understand these securities, so we don't permit our banks to use them. We leave them to the advanced nations like you."

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