March 9, 2008 7:31 pm

In the grip of implacable subprime forces

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Months into the subprime meltdown, economists and policymakers in the US seem no closer to agreement about what, if anything, to do. Last week Hank Paulson, Treasury secretary, and Ben Bernanke, Federal Reserve chairman, were at odds over how to stem mortgage foreclosures. Mr Bernanke called on banks to be more willing to reduce principal. Mr Paulson said voluntary adjustments to mortgage rates and payment schedules were working.

For the moment, both men are merely exhorting – moral suasion, it used to be called. Mr Bernanke is not yet proposing that banks should be compelled to write down loans, and Mr Paulson notes that voluntary writedowns are among the options his “Hope Now” alliance of mortgage lenders and servicers can choose if they wish. Still, the tone of their comments was different. Whether he means to or not, Mr Bernanke continues to signal mounting alarm at the economy’s prospects.

As well he might. February saw the biggest drop in non-farm payrolls for five years – 65,000, more than twice what the market expected. In the fourth quarter of 2007, more than 2 per cent of the country’s 46m mortgages were in foreclosure, and nearly 6 per cent past due date – both sharply higher than a year ago. For subprime mortgages, the numbers were 13 per cent in foreclosure and 20 per cent past due. House prices have much further to fall – maybe another 20 per cent, analysts say. That will drive many more borrowers into negative equity and force the pace of foreclosures still higher.

As the value of mortgage-backed securities has fallen, the supply of all credit has tightened – forcing investors to dump assets into falling markets, driving values down further and tightening the credit-supply screw another turn. Highly leveraged hedge funds are facing margin calls and, in many cases, huge losses. The effects are sure to spread further. One new study* considers a central case in which losses in the banking system are $200bn, wider losses $400bn and the resulting shrinkage in credit $900bn – enough to cut growth in gross domestic product by between 1 and 1.5 percentage points. (This examines just the financial channel; other effects of falling house prices on the economy are excluded.) The arch-pessimist Nouriel Roubini, who has been proved right more than once over the past year, envisages an even worse scenario, in which loan losses could total $1,000bn.

There may be little or nothing the authorities can do to arrest these forces, but politics will insist they try. For the moment, foreclosures are the focus of attention. Congress is considering changes to bankruptcy laws, making it harder for lenders to foreclose and allowing judges to write down mortgage principal as part of a bankruptcy proceeding. Mr Paulson is opposed: he says it would slow the flow of future lending. Moreover, this approach only discourages lenders from foreclosing. Increasingly, borrowers who owe more than their houses are worth are choosing to walk away from their debts.

They call it “jingle mail”: the borrower posts the keys to the lender. Social stigma, together with a self-interested regard for one’s credit status, has inhibited this in the past. But walking away seems to be catching on; it may soon be all the rage. If so, as house prices continue to fall – leaving as many as 20m in negative equity, on some estimates – the lenders’ losses could exceed even Mr Roubini’s estimates.

The line that “falling house prices are good for the economy – they help clear the market” is no doubt correct, but it will be difficult to sustain if anything like that worst-case scenario begins to unfold. Then the challenge will be to confine political action to measures that do relatively little harm, and to avoid palliatives that will only amplify the cycle of recklessness and remorse next time round.

This seemingly obvious point is widely ignored in Washington. The US already has what must be the world’s most generous fiscal dispensation for mortgage borrowers – uncapped tax relief for owner-occupiers, plus colossal “government sponsored entities” to guarantee loans, implicitly subsidise mortgage rates and promote securitisation. This fiscal regime created an environment in which you felt a fool unless you borrowed to the hilt – not just to buy your house but to keep your equity in it to a minimum, so as to liberate cash for other purposes. This is the very root of the problem. Yet favoured responses to the subprime crisis on Capitol Hill include extensions of tax relief to poorer households (at present, it goes only to taxpayers who itemise their deductions), further vast expansions of the remit of, and resources potentially available to, the GSEs, and assorted new outright subsidies.

Adjusting the bankruptcy laws to encourage writedowns and make repossession more difficult may do little to help right now, but it does at least have the virtue of making no new demands on taxpayers. If it makes lenders think twice in future about extending 100 per cent mortgages to borrowers with no income or assets, so much the better – although “jingle mail” may prove even more salutary in that regard. The medium-term goal for policy should be less subsidy of every sort for borrowing, and stricter regulation of lenders. The short-term goal should be to avoid actions that militate against the medium-term goal. That sounds timid, I know, but at times like this being timid is a lot to ask.


*Leveraged Losses: Lessons from the Mortgage Market Meltdown. By David Greenlaw, Jan Hatzius, Anil Kashyap and Hyun Song Shin. www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf

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