If I were asked by a member of Congress for advice in the current mess, here’s what I would say.
1. Don’t Panic.
The events on Wall Street seem terrifying partly because the U.S. has not been through a financial panic like this since the Great Depression. But plenty of other countries, even rich countries like Sweden and Britain, have had financial panics in the last few decades, and have worked their way out of them without drastic consequences. So, keep your cool. (Once, when an overwrought friend complained to Adam Smith that some political setback would be the ruin of the British nation, Smith replied “There’s a lot of ruin in a nation.”)
2. Don’t Let Unrelated Issues Get Confused
There seems to be a concerted effort to tie together separate aspects of the financial crisis which are not in fact connected. For example, I think the Fed can make a strong case for ensuring that money market mutual funds do not “break the buck” (the term for what happens when they cannot guarantee that depositors will get back at least the full principal value of their money). But this has very little to do with whether the government should buy up subprime mortgage securities. Do not get stampeded into making a bad decision about subprime mortgages by a suggestion that such a decision is necessary to avoid “breaking the buck.”
3. Don’t Get Stuck Holding the Bag
Increasingly it seems that there are a lot of desperate schemes to try to force/trick the government into taking the “toxic waste” subprime securities off the hands of the entities who are holding them now. In the end, some solution where the government ends up holding some of this stuff may be unavoidable. But what is eminently avoidable is a solution where basically the government gets only the toxic waste and none of the good assets. Any specific rules you come up with that say “we will take any securities you want to sell that meet the following criteria” will induce the owners of those securities to dump the bad stuff on the government and keep the good stuff for themselves. This is what economists mean when they say that the worst possible solution is one where you “socialize the losses and privatize the profits.”
Let me give you a concrete, personal, specific example. Last year, the condo next to my parents was bought by one of these shady real estate speculator types who started cropping up everywhere in the last few years. He was one of the last people in the country, I think, to get one of those subprime mortgages from Countrywide where the interest rate is incredibly low for two years and then skyrockets. Of course, his plan was to flip this property before the two years ran out, on the theory that housing prices could only increase. Oops! Now he is holding the bag — he’s still trying to sell, for $50,000 more than he paid, but there are no buyers.
Suppose Congress passes a bill that says everybody’s rates will freeze at the level that prevailed in the first two years of their mortgage. Then this guy, who is one of the sleazy bad actors who were responsible for much of this crisis, is off the hook, because his teaser interest rate was absurdly low so he can afford to keep the place indefinitely!
I realize Congress has tried to deal with this kind of situation by insisting that government guarantees are available only for people who live in their property. But this guy is a pathological (and very successful) liar. He will have zero difficulty in producing documentation proving that the 5 different houses he was holding when the music stopped are all his principal residence. Of course, eventually all this will catch up with him, and he will be prosecuted and convicted. But meanwhile, if the government says it will guarantee any mortgage that meets certain criteria, the owner of the securities that include this guy’s loans has an incredibly strong incentive conveniently not to notice that the guy is a crook. Once they get into the government guarantee program, the fact that he is a crook is the government’s problem and not theirs. So the government will end up being the owner of all 5 of those toxic waste loans, and once he is caught and prosecuted and convicted there is no way to squeeze blood from that stone to make the taxpayer whole.
Whoever was foolish enough to give those mortgages to that guy needs to bear the losses. If they go bankrupt, then they deserve to go bankrupt. The taxpayer should NOT be bailing these guys out.
The problem, in a nutshell, is that the owners of the subprime securities know much more than the government about exactly which of their loans are to the deadbeats who will never repay. (The technical term for this is “adverse selection” — it’s different from, but related to, moral hazard). So if the government stands ready to buy any mortgages that match some certain set of objective criteria, what the government is going to get is all those mortgages that satisfy the criteria but are nevertheless rotten to the core.
4. Give Something, Get Something
It may well turn out that a massive bailout of the financial sector is the only way to prevent catastrophic consequences for the economy as a whole. But there is no reason for the government just to get the toxic waste and get nothing in return. The government needs to get the upside as well as the downside, the good as well as the bad. If a financial firm comes begging for a bailout, the response should not be “OK, we’ll take the subprime securities off your balance sheet” nor should it be “We, the government, will buy the subprime securities in the marketplace for 10 times what they’re worth in order to help you out.” The government needs to drive a hard bargain: In the limit, the government should get shares of the firm’s assets that bear some relationship to the value of any guarantees the government gives for the subprime securities the firm owns. If the firm goes bankrupt, the government needs to be first in line among the creditors as the assets get sold off.
5. What’s Good For The Stock Market Is Not Necessarily Good For the Country
There’s a tendency to use the stock market as a gauge of whether a proposed solution is “real” or not. But the stock market is a measure of whether a proposal is good for the stock market, not whether it is good for the economy as a whole. For example, suppose that there was a proposal to tax every living American $10,000 and use the proceeds to buy stocks. This would produce a huge stock market rally, but would be a terrible deal for anyone who had to pay the$10,000 and didn’t own stocks. Roughly speaking, I am concerned this might be the right explanation for the stock market rally late last week: Not an assessment that the ideas being floated were good in any broad sense, just that they were good in the sense of letting a lot of people who had made very bad decisions on Wall Street off the hook, at the expense of the taxpayer.
6. Mark to Market
I mentioned Sweden and Britain earlier as examples of countries that had survived financial market panics without the ruin of the nation. But there are less hopeful examples as well. Japan spent more than a decade in the economic wilderness after the collapse of its bubble economy in the early 1990s.
Fundamentally, Japan’s mistake was a refusal to own up to the facts. They kept hoping that the problems could just be swept under the rug, and ignored, and if ignored long enough maybe they would go away. There is a consensus among economists that this is the most costly policy mistake in a developed country since the Great Depression. It resulted in a lost decade of growth for Japan. If the Japanese had formed a Resolution Trust Corporation to sell off distressed assets and taken the pain in the short run, they would have been much better off in the long run.
There’s a similar fear now of solutions that might result in a lot of foreclosed houses or subprime mortgages coming on the market and driving prices down further. I think these concerns reflect the same reluctance to face the music that Japan felt. It reminds me of the old adage about how, if you want to chop the tail off a dog, do it in one swift stroke, not one joint at a time. The Japanese did it one joint at a time.
It will also be painful to many people if the stock market has to fall another 20 or 30 percent. But it is not the end of the world. And trying to avoid the inevitable, as Japan did, may just make the ultimate reckoning much worse (as it did in Japan’s case, or as happened with the S&L crisis in this country two decades ago). There are plenty of countries around the world that have survived stock market declines of 20 or 30 percent; indeed, in real dollars, the stock market in the U.S. fell by almost 50 percent around the time of the 1973-74 recession. It was painful, but not catastrophic.
7. Ben Bernanke is the taxpayer’s friend. Henry Paulson is Wall Street’s friend. If they disagree, or if there is the tiniest hint that Bernanke isn’t very enthusiastic about something that Paulson is proposing, don’t do it.
Bernanke is the person at the center of the storm who I think deserves the greatest confidence that he wants to do what’s right for the economy as a whole, not necessarily just for Wall Street. I know Bernanke personally and he is a person of the highest integrity and of truly awesome intellect. And, I think, real wisdom. He is not a Wall Street shill.
Having said all of that, the pressures he is under are monumental and the situation is extremely complex and fluid. He may find himself in a position where he thinks the independence and authority of the Fed could be destroyed if he does not go along with a bailout of Wall Street interests. That would be an agonizing choice for him, because fundamentally (and rightly) he believes that an independent Fed is the cornerstone of a sound economy. He will be maneuvering for the maximum ability to do what is good for the taxpayer, but that does not necessarily mean he could not be forced into a position of supporting deals that Congress should not approve.
8. Establish some “safe havens” for sound mortgage lending practices, and then let bankruptcy judges reset the terms of mortgages that in their judgment did not meet those standards It is very clear that a lot of shady practices developed over the past few years of the mortgage lending boom. The Fed is now engaged in a process of trying to create more rigorous truth-in-lending standards to prevent some of the recent abuses from recurring
One step that might be valuable would be to define some “safe haven” characteristics of mortgage products that are sufficiently simple and clear and common that the borrower can be presumed to have understood them. This would cover probably 90 or 95 percent of all the mortgages made over the past 10 years.
But once the “safe haven” characteristics have been defined, I think it would be appropriate to give the power to bankruptcy judges to rule in specific cases that a mortage product that did not conform to those rules was effectively an invalid contract, whose terms can be redefined in the bankruptcy proceeding. One would need to be very careful here not to open the door too wide, because many of the 5 percent of mortgages that did not conform to such safe haven rules were still legitimate products. And there would need to be an explicit determination that if a higher interest rate was charged in order to account for the borrower’s higher risk of default, that does NOT constitute an unsound or dubious practice. (Risk-based pricing is a key reason that many minority and other kinds of previously- excluded people were able to get mortgage loans over the past 10 years; it is critical here not to throw out the baby with the bath water).
In the medium run, I think we need to rethink the standards for how to make sure that consumers know what they are getting themselves into when they sign a mortgage contract; in particular, I think it would be a good idea to require a video or audio recording of the borrower saying, in their own words, what they understand the terms of the mortgage to be. If that borrower subsequently ends up in bankruptcy court, this could prove decisive evidence on whether or not the borrower went into the deal with eyes wide open.
9 .Securitization is not the problem.
There has been a lot of chatter about how maybe this crisis is a consequence of fundamental flaws in the whole idea of bundling mortgages together into big securities that can then be traded and distributed around the country or the world.
These criticisms are (mostly) misguided. The problem is not with securitization per se. Securitization has permitted a vast expansion in the number of people who can get mortgages and a remarkable reduction in the interest rates that they pay on those mortgages.
The problem is that those securities are much more complex and opaque than more traditional securities, and our securities regulators have not required nearly enough information to be disclosed about the details of what is in these securities. A reform that required any securitized mortgage-backed security to disclose every single bit of information that the originator has about the mortgages encompassed in the security could have provided for much more transparent valuations of these securities, and might have prevented many of the highly questionable loans that were granted in the last few years from ever having been made. Justice Louis Brandeis said it a long time ago: Sunlight is the best disinfectant.