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					                           US HOME MORTGAGE CRISIS:

                               HOW BAD WILL IT BE?

                              CAUSES AND SOLUTIONS

                                     by Fred Moseley

                                 Mount Holyoke College


       The US economy is currently experiencing its worst financial crisis in decades,

perhaps the worst since the Great Depression. The financial crisis started in the home

mortgage market, especially the so-called “subprime” mortgages, and is now spreading

beyond subprime to prime mortgages, commercial real estate, corporate junk bonds, and

other forms of debt. Total losses of US banks could reach as high as half of the total

bank capital, which would lead to a sharp reduction in bank lending, which in turn could

cause a severe recession in the US economy.

       The paper analyzes the causes of the current home mortgage crisis, with emphasis

on speculative finance, the securitization of mortgages, and the role of investment banks.

The paper also estimates of how bad the mortgage crisis is likely to be, and how

significant its effects on the US economy as a whole are likely to be. Then, the

government economic policies pursued so far (by both the Fed and Congress) to deal with

the crisis are discussed. The final section makes recommendations for more radical

government policies that the Left should support in response to this crisis.

1. The US home mortgage market

1.1 US home mortgage market before 1980

          The US home mortgage market before 1980 is illustrated in Figure 1. As we can

see, it was a relatively simple market. Mortgages were lent by commercial banks to

home buyers, and the commercial banks generally continued to own the mortgages for

their duration (usually 30 years). The commercial bank was often a local bank with local

owners, so there was often something of a personal relation between the bankers and the

homeowners. If a homeowner got into temporary financial difficulty for some reason, the

banks would often be willing to modify the terms of the mortgage in order to avoid

foreclosure (as in the classic James Stewart movie about the Great Depression “It’s A

Wonderful Life”). This simple mortgage market has been described as the “3-6-3” plan,

which means: “pay 3% on saving accounts, earn 6% on mortgages – and be on the golf

course by 3 o’clock!”

          This simple mortgage market was also highly regulated. The most important

regulations were as follows: (1) interest was prohibited on checking accounts and there

were maximum rate of interest on savings accounts (Regulation Q), and (2) commercial

banks and investment banks were strictly separated (Glass-Steagall Act). Investment

banks played no role whatsoever in this simple mortgage market in the early postwar


          This simple and highly regulated mortgage market was fairly stable and crisis

free. Home mortgage foreclosure rates during this period were never higher than 0.5%;

we will see below that the mortgage foreclosure rate today is about 2.5%, and could go as

high as 10% in the next year or two.

       The role of Fannie Mae (Federal National Mortgage Association) in this early

postwar mortgage should also be mentioned. Fannie Mae was created in 1938 in an

attempt to provide more funds to the home mortgage market. It continued to fulfill this

function in the early postwar period. It purchased approved mortgages from commercial

banks, who could then use these additional funds to originate additional mortgages.

Fannie Mae was privatized in 1968, in order to reduce the budget deficit (a short-sighted

goal, if there ever was one), and also to help pay for the Vietnam War. In 1970, Freddie

Mac (Federal Home Loan Mortgage Corporation) was created as another private

corporation, in order to provide competition for Fannie Mae.

1.2 US home mortgage market since 1980 (until recently)

       In the last quarter century, immense changes have taken place in the home

mortgage market in the US, and these changes have made the mortgage market much

more complicated and much more unstable, and have contributed as causes to the current

crisis. Figure 2 attempts to illustrate the main features of the US home mortgage market,

as it has developed since the early 1980s. The arrows point in the direction that the

money (or loan) flows, and the ownership of the mortgages flow in the opposite direction.

The rectangles are financial institutions and the circles (or ovals) are financial


       The first major change / cause was the deregulation of this market beginning in

the early 1980s. The government regulations mentioned above were eliminated: the

ceiling on interest and the separation between commercial banks and investment banks.

This deregulation made possible all the other changes that will be discussed below and

that led to the current crisis.

        The second important change / cause was the securitization of mortgages.

Commercial banks who originally created the mortgages for homeowners no longer held

onto these mortgages “in their own portfolio”, but instead sold the mortgages to

investment banks, who pooled together hundreds and even thousands of mortgages as

“mortgaged-based securities” (MBS). The investment banks then sold the mortgage-

based securities to hedge funds, structured investment vehicles (SIVs) and conduits,

pension funds, and foreign investors (more on these final owners of the mortgages

below). Investment banks were the “prime movers” of this securitization process. Not

only were they the creators of the mortgage-based securities, they also often loaned

money to the hedge funds so they could purchase the mortgage-based securities. In

addition, a new financial institution arose in addition to commercial banks to “originate”

home mortgages and sell them to investment banks – so-called “mortgage companies”,

such as Countrywide (which is the largest mortgage company in the country). (The

securitization of mortgages was pioneered by Freddie Mac and Fannie Mae in the 1970s,

but these “government sponsored enterprises” only purchased prime mortgages that met

certain criteria of creditworthiness (i.e. were “conforming” mortgages) and were insured

by the FHA. Freddie Mac and Fannie Mae play no role in the “innovative” (i.e. very

risky) mortgages to be discussed below.)

        One important result of the securitization of mortgages is that the “originators” of

mortgages – commercial banks and mortgage companies – no longer had a financial

incentive to make sure that the homebuyers are creditworthy and are likely to be able to

keep up with their monthly mortgage payments. Indeed, these originators have perverse

financial incentives to lower credit standards and to ignore possible problems with

creditworthiness, both because they will soon sell the mortgage to other investors, and

also because they earn their income from “origination fees”, not from the eventual

monthly mortgage payments. So the more mortgages originated, the more fees, and the

more income for the originators, no matter what the creditworthiness of the borrowers

might be (or not be).

       Investment banks have a similar perverse incentive in their role as brokers or

middlemen in the securitization process. Investment banks primarily buy mortgages from

the originators and sell them to the final investors, and make most of their money from

“processing fees” (or “transaction fees”). So again, the more mortgage-based securities

sold, the more fees and income for investment banks, no matter whether or not the

borrowers would be able to make their payments down the road.

       But didn’t someone care about and pay attention to the creditworthiness of the

borrowers? Surely the final investors or owners of the mortgage-based securities should

have cared. However, these mortgage-based securities are extremely complicated and

consist of hundreds or thousands of mortgages. It is a very time-consuming and tedious

task to carefully examine the creditworthiness of such large numbers of borrowers.

Therefore, the final investors depended to a large extent on the bond rating agencies

(Moody’s, Standard and Poor’s, Fitch’s) to evaluate the risks in the mortgage-based

securities and to assign “ratings” to them, similar to their rating of corporate bonds. The

highest rating for the lowest risk securities is AAA, and the ratings go down there as the

risk of the securities goes up.

       However, there was also a perverse incentive at work with the rating agencies as

well. Rating agencies are private, profit-making businesses, who compete with one

another for the rating business of the investment banks. Rating mortgage-based securities

became a very lucrative business in recent decades, along with the growing securitization

of mortgages. Therefore, there was (and continues to be) a very strong incentive for the

rating agencies to give the highest AAA rating to even risky mortgage-based securities,

so they will continue to get the business of these investment banks in the future. Plus the

personnel of the rating agencies were often wined and dined and golfed by the investment

banks, as further inducement for a AAA rating. It has recently come out that, in some

cases, investment banks requested that specific employees of the rating agencies be

removed from the rating of their mortgage-based securities, because of the “excessive

diligence” of these employees, and these requests were generally granted.

       In sum, the securitization of mortgages was a process that was filled with perverse

incentives to ignore the credit risks of the borrowers, and to make as much money as

possible on processing fees.

       As a result of this system of perverse incentives, mortgage originators became

very “innovative” (especially the mortgage companies). To begin with they expanded

into subprime mortgages, i.e. mortgages to low-income families who previously would

not have qualified for mortgages (including many African-American and Latino families

and single parents). In 1995, less than 2% of all mortgages were subprime, but 25% of

mortgages were subprime in 2005. In order to compensate for the higher risk of these

subprime mortgages, the rate of interest would be higher than for prime mortgages.

       However, another innovation was required in order to make these more expensive

mortgages affordable for low-income families, at least for a few years – the so-called

“teaser” rates of interest, that would initially be low and then would be adjusted up

(“reset”) after 2-3 years. One might say that this was a very short-sighted strategy, since

even if the mortgages were affordable at the initial low “teaser” rates, they would

certainly not be affordable after the mortgage rates were reset.

       The solution to this problem was another strategy – the refinancing of mortgages

before the low initial teaser rates were reset. This strategy took advantage of the

continual increase in the prices of houses during these years. As long as house prices

were rising, a new mortgage could be taken out for more money, with another low initial

teaser rate, and the money from the new mortgage could be used to pay off the old

mortgage before the rates were reset. However, this strategy works only as long as

housing prices are increasing. When housing prices stopped increasing in 2006, this

strategy no longer worked. Old mortgages could no longer be refinanced, so the

borrowers were stuck with higher reset mortgage rates that they could not afford, and the

default rates started to increase. More on this below.

       Other innovations of the originators included: documentation as proof of one’s

income and assets was no longer required (commonly called “liar loans”), and little or no

down payment was required, so that the borrower started out with little or no equity in the

house. The prize for innovative mortgages goes to the so-called “NINJA” mortgages –

which stands for “no income, no job, and no assets” – and yet borrowers still somehow

“qualified” for a home mortgage! Several mortgage companies actually advertised

“NINJA” mortgages with pictures of green turtles. It is obvious that the perverse

incentives of the originators – the more mortgages, the more income – resulted in risk-

taking in the extreme, with the risks being passed on to others.

       As noted above, the final buyers or owners of mortgage-based securities consisted

mainly of hedge funds, conduits and SIVs, pension funds, and foreign investors. The

precise nature of the “foreign investors” is not well known, but includes foreign banks

and foreign pension funds. US pension funds generally can invest only in AAA rated

securities, so their purchases of mortgage-based securities depended entirely on the

cooperation of rating agencies.

       The most risk-taking of the final investors were the hedge funds, SIVs and

conduits. Hedge funds are private investment funds, similar to mutual funds, except that

they are only for the wealthy; they typically require a minimum investment of $100,000

or more. Conduits and SIVs are financial entities set up by commercial banks, but are

separate from the banks themselves and thus they are “off the balance sheet” of the

banks. In what follows I will use “hedge funds” as short-hand for “hedge funds, conduits

and SIVs”, since their role in the home mortgage market was essentially the same.

       Since hedge funds (etc.) are not regulated, they are free to engage in risky

investment strategies. They tended to buy the riskiest mortgage-based securities with the

highest yields. And most risky aspect of the business strategy of hedge funds is that the

money they use to buy mortgage-based securities is mostly not their own money, but is

instead short-term loans obtained on the “money market” by selling “commercial paper”

(loans that come due in 90 days or less) (hedge funds also borrowed short-term loans

from investment banks).

       This business strategy is generally profitable because long-term interest rates on

mortgages are generally higher than interest rates on short-term loans. However, this

business strategy is also risky because it depends on the willingness of the short-term

lenders to continue to loan to the hedge funds. In order be able to pay off their short-term

loans as they become due, the hedge funds must obtain new short-term loans, i.e. they

must “refinance” or “roll over” their short term loans. If something happens (like

increasing defaults on mortgages), and the short-term lenders lose confidence in the

hedge funds, and are no longer willing to “refinance” the hedge funds (i.e. the “money

market freezes up”), then the hedge fund would be in danger of bankruptcy. It could

perhaps avoid bankruptcy by selling some of its assets, but if the same thing is happening

to many hedge funds at once, then the “fire sale” of their assets would only make the

crisis worse by drastically reducing the prices of these assets.

       This risky type of business strategy, which depends on the continual refinancing

of short-term loans has been called “speculative finance” by Hyman Minsky, a Post-

Keynesian economist, whose work was mostly ignored for decades, but is now receiving

more attention, because it seems to explain a lot about the current crisis. Because of its

riskiness and “fragility”, Minsky argued that a financial system with large amounts of

speculative finance should be very closely supervised and regulated by the government.

However, as we saw above, there was little or no government regulation of the US home

mortgage market in recent decades, and no regulation whatsoever of hedge funds, so the

risks continued to escalate and the financial system became more and more fragile.

       Furthermore, what has become clearer in recent months as the crisis has

developed is that hedge funds, conduits and SIVs were not the only financial institutions

in the market for mortgage-based securities that was engaged in speculative finance.

Mortgage companies and more importantly investment banks were also engaged in

speculative finance. Mortgage companies were not selling all the mortgages that they

originated, but were also hanging on to some of them. And the funds used to fund these

long-term mortgages were short-term commercial paper funds, which required continual

“refinancing” in order for the mortgage companies to meet their short-term debt


       Most importantly, investment banks were also engaged in massive speculative

finance. Investment banks were not passing on to hedge funds, etc. all the mortgage-

based securities that they created, but continued to own some of them “on their own

account”. And, once again, the funds that the investment banks used to purchase the

mortgage-based securities for themselves were short-term commercial paper funds, which

required continual “refinancing” in order to be viable. This is what happened to Bear

Sterns in late March – it was not able to “refinance” its short-term debt that it had used to

purchase risky but high-profit mortgage-based securities, and so would have gone

bankrupt without the Fed bailout (more on the Fed’s bailout of Bear Sterns below).

The degree of debt leverage of the investment banks was extraordinary and was another

source of instability. Commercial banks typically have a debt to capital ratio of about

10:1. Investment banks in recent years have had much higher “leverage” ratios of 20:1

and even 30:1. Bear Stearns was reportedly has had one of the highest leverage ratios

among the investment banks, and that is one of the reasons it was so vulnerable when the

short-term lenders began to refuse to refinance Bear Stearns’ debts. The incentive for

such high debt to capital ratios is of course that the “return to capital” (the ratio of profit

to capital) is correspondingly higher. And since there was no government regulations or

capital requirements for investment banks, as there are for commercial banks, investment

banks were free to push their leverage ratios to the limits of prudent finance and beyond.

One financial analyst has said that “allowing investment banks to be leveraged to the tune

of 30:1 is like playing Russian roulette with 5 of the 6 chambers closed. If one adds the

off-balance liabilities [e.g. SIVs] to this leverage, you might as well put a bullet in the 6th

chamber and pull the trigger.”

        All in all, we can see that the US home mortgage market as it has developed in

recent decades was a very fragile and unstable financial system. To begin with, this

market was filled with speculative finance, which is inherently unstable and vulnerable to

disruptions and crises, because of the continual need to refinance short-term loans. On

top of that, the long-term mortgages that were purchased with short-term funds were

risky in the extreme, with “teaser rates”, “liar loans”, “NINJA” mortgages, etc.

Furthermore, on top of all that, this very fragile financial system was almost completely

unregulated, so the financial “innovators” were free to do pretty much whatever they

wanted to, including taking on more and more risk in search of higher and higher profit.

Finally on top of all that, this market was also filled with perverse incentives, that led

mortgages to give mortgage companies to borrowers who could not afford them, and led

rating agencies to give AAA ratings to these very risky mortgages that did not deserve

them. In retrospect, it seems obvious (and to many in advance) that the US home

mortgage market was an accident waiting to happen.

   3. Effect on the real economy

       All this speculative finance and financial innovations greatly increased the supply

of credit available for home mortgages, and led to a housing boom and bubble. The

increased supply of credit increased the demand for houses, which in turn increased

housing prices at an unprecedented rate. Figure 3 shows “real housing prices” (i.e. actual

housing prices corrected for the general rate of inflation of current output) from 1890 to

the present. This is one of the more remarkable graphs that I have seen in my 30 years as

an economist. We can see that from 1945 to 1995, real housing prices remained roughly

constant (i.e. housing prices increased at about the same rate as the general rate of

inflation). Then, beginning from 1995 to 2005, real housing prices completely broke

with this historical pattern and almost doubled (actual housing prices increased 10-15% a

year, while the general rate of inflation was 2-3%).

       This rapid increase in the prices of houses led to a housing construction boom,

which also had “multiplier effects” in the durable goods industries related to housing

(furniture, appliances, etc.) This rapid increase in the prices of homes also helped to

stimulate consumer spending over the last decade, in two main ways: (1) to begin with,

what economists call the “wealth effect” – increasing wealth (in this case, increasing

housing wealth) makes households feel wealthier, so they spend more for consumer

goods; increasing wealth also means that families do not have to save as much for the

future and therefore they can spend more now.

       (2) Even more importantly, consumer spending has also been stimulated by the

phenomenon of “mortgage equity withdrawals” (MEWs) – in which households take out

or borrow some of the equity that they have in their homes and use this money to finance

more consumption. MEWs reached unprecedented levels of $600-800 billion in recent

years, made possible by the rapidly rising housing prices. Various studies have estimated

that approximately half of the money obtained through MEWs in recent years has been

used to finance more consumer spending (e.g. another car, a vacation trip, etc.). On the

basis of this assumption, one can estimate the amount of consumer spending that has

been financed by MEWs in recent years, and also estimate what consumer spending

would have been without the MEWs, and what the rate of the growth of the economy

would have been without this extra boost of consumer spending financed by MEWs.

The resulting estimates are shown in Figure 4, which shows for each year the actual rate

of growth (the black bar on left-hand side) and what the rate of growth would have been

without the MEW (the gray bar on the right-hand side). We can see that in the late

1990s, the actual rate of growth was 3.5 to 4.5% a year, and the MEWs contributed about

1 percentage point of that 3 or 4 percentage points of growth. However, in the early

2000s, the actual rate of growth was about the same, but much more of that growth was

due to the MEWs. Without the MEWs, the rate of growth during this period would have

been a meager 1% a year, instead of the more robust 3-4%. And we can also see that the

mild recession in 2001-02 would have been much worse without the MEWs. On an

annual basis, the economy even slightly increased during these recession years. But

without the MEWs, the economy would have declined 1% in both years, and would have

declined even more on a quarterly basis. We will come back to the importance of the

MEWs below.

       If we add to this MEW effect the wealth effect and the contribution of the

residential construction boom, it appears that almost all of the growth of the economy in

recent years has been due directly or indirectly to the housing bubble. Which bodes ill

for the future, because the housing bubble has now burst, which means that the economy

is going to have to get along with this added stimulus to growth, which could mean a

more severe recession and a prolonged period of slower growth. Some other source of

growth must be found, and it is not clear what that other source would be.

3. The mortgage credit crisis: how bad will it be?

       The housing bubble started to burst in 2006, and the decline accelerated in 2007.

Housing prices stopped increasing in 2006 and started to decrease in 2007, and have

fallen 10-15% so far. This meant that homeowners could no longer refinance when the

mortgage rates were reset, which caused delinquencies and defaults of mortgages to

increase sharply, especially among subprime borrowers. From the 1st quarter of 2006 to

the 1st quarter of 2008, the total number of mortgages in foreclosure more than doubled,

from 1% to 2.5%, and the number of mortgages in foreclosure or at least 30 days

delinquent increased from These foreclosure and delinquency rates are the highest since

the Great Depression; the previous peak for the delinquency rate was 6.8% in 1984 and

2002. These defaults have meant losses for all the lenders in the mortgage market.

       Furthermore, as soon as the trouble started, many of those lender that were

engaged in speculative finance could not refinance their short-term borrowing, because

the short-term lenders no longer had confidence in the long-term mortgages used as

collateral for the short-term loans. As a result, a number of mortgage companies and

hedge funds have gone bankrupt and will continue to go bankrupt. Countrywide, the

largest mortgage company, was bailed out by Bank of America, which now looks like a

bad decision on the part of BofA.

       So far (as of June 2008), there have been about 1 million mortgage foreclosures.

Estimates of the total number of foreclosures that will result from this crisis range from 3

million (Goldman Sachs, IMF) to 8 million (Nuriel Roubini, a New York University

economic professor, whose forecasts carry some weight because he was one of the first to

predict the bursting of the housing bubble and the current recession). The main reason

for this difference is as follows: one of the main causes of foreclosures in the months

ahead will be the phenomenon of “negative equity”. “Negative equity” means that the

homeowner owes more money to the lender than the house is currently worth (this

phenomenon is also called “under water”). Negative equity results from little or no down

payment to begin with, combined with falling housing prices. If one put no money down

on a house, and the price of the house has declined by 20%, then the home “owner” owes

20% more than the house is currently worth. Home “owners” in this situation have an

incentive to stop making payments on their mortgage and “walk away” from their house.

This type of default has been called “jingle mail” because the home “owner” figuratively

puts the keys to the house in an envelope and mails them back to the bank, and says “you

can have it”.

       No one has a very precise estimate of the percentage of homeowners with

negative equity that are likely to “walk away” from their mortgage and house, since this

has not happened before on anything like this scale. Some think that there is a “social

norm” against just walking away, and that this will impede homeowners from taking this

route. However, if some homeowners start to walk away, because of the clear financial

incentives, others may follow, and it could quickly become more socially acceptable.

Speculators especially (those how have bought houses not to live in them, but to resell

them later at a higher price) have a very strong incentive to walk away and no reason not

to. The low 3 million estimate of foreclosures assumes that 20% of homeowners with

negative equity will be forced into foreclosure and will walk away, and the high estimate

of 8 million assumes that 50% of homeowners with negative equity will be forced into

foreclosure or walk away. Perhaps the reality will lie somewhere in between.

       As already mentioned, there have already been about 1 million foreclosures. As

of May 2008, another 1 million mortgages were 90 days delinquent (foreclosure notices

usually go out after 90 days), and another 2 million were 30 days delinquent. Therefore,

a total of 4 million mortgages were either in foreclosure or close to it at this time. These

data make the low estimate of 3 million foreclosures look too low.

       Defaults and foreclosures on mortgages mean losses for the lenders. Estimates of

losses on mortgages for the financial sector as a whole range from $500 billion to $1

trillion, depending mainly on the number of foreclosures. In addition to losses on

mortgages, there will also be losses on other types of loans, due to the weakness of the

economy in the months ahead: consumer loans (credit cards, etc.), commercial real

estate, corporate junk bonds, and other types of loans (e.g. credit default swaps).

Estimates of losses on these other types of loans range from $400 billion to $700 billion.

Therefore, estimates of the total losses for the financial sector as a whole as a result of the

crisis range from around $1 trillion (Goldman Sachs, IMF) to $1.7 trillion (Roubini).

(Actually Roubini’s $1.7 trillion estimate is his “optimistic” scenario. He also has a

“pessimistic” estimate of $2.7 trillion (!) of total losses, which assume a 25% reduction of

housing prices, rather than a 20% reduction, which in turn would result (according to

Roubini) in 21 million mortgages with negative equity and 10.5 million foreclosures.)

       It is further estimated that about half of the total losses of the financial sector will

be suffered by banks. The rest of the losses will be borne by non-bank financial

institutions (hedge funds, etc.). Therefore, dividing the total losses for the financial

sector as a whole in the previous paragraph by 2, estimates of the losses for the banking

sector range from $450 billion to $850 billion. Since the total bank capital in the US is

approximately $1.5 trillion, losses of this magnitude would wipe out from one-third to

one-half of the total capital in US banks. This would obviously be a severe blow, not just

to the banks, but also to the US economy as a whole.

       The blow to the rest of the economy would happen because the rest of the

economy is dependent on banks for loans – businesses for investment loans, and

households for consumer loans. Bank losses result in a reduction in bank capital, which

in turn requires a reduction in bank lending, in order to maintain acceptable loan to

capital ratios. Such a reduction of bank lending is commonly called a “credit crunch”.

Assuming a loan to capital ratio of 10:1 (this conservative assumption was made in a

recent study by Goldman Sachs), every $100 billion loss and reduction of bank capital

would normally result in a $1000 billion (i.e. $1 trillion) reduction in bank lending, and

corresponding reductions in business investment and consumer spending. According to

this rule of thumb, even the low estimate of banks losses of $450 billion would result in a

reduction of bank lending of $4.5 trillion! This would be a severe blow to the economy

and would worsen the recession.

       Banks losses may be offset to some extent by “recapitalization”, i.e. by new

capital being invested in banks from other sources. If capital can be at least partially

restored, then the reduction in bank lending does not have to be so significant and

traumatic. So far, banks have raised about $200 billion in new capital, most of it coming

from “sovereign wealth funds” financed by the governments of Asian and Middle Eastern

countries. So ironically, US banks may be “saved” (in part) by increasing foreign

ownership. US bankers are now figuratively on their knees before these foreign investors

offering discounted prices and pleading for help. US government officials are not sure

what to think about this increasing foreign ownership of major US banks. It is also an

important indication of the decline of US economic hegemony as a result of this crisis.

       In addition to the credit crunch, consumer spending will be further depressed in

the months ahead because the “wealth effect” (discussed above) is now working in

reverse, and the positive “MEW effect” (also discussed above) no longer exists. We saw

above that without the MEW effect, the 2001-02 recession would have been worse than it

was. Now we are going to have such a recession without any offsetting MEW effect.

Plus $4 a gallon for gasoline will have a further negative effect on consumer spending

and the economy. The recession in turn will increase both business and household

bankruptcies, leading to further losses for banks, in a vicious cycle. All in all, it could be

a severe recession.

4. Government policies

       Can government policies by the Fed and Congress save us from such a severe


4.1 The Fed

       The Fed has responded very aggressively, and in unprecedented ways, to try to

stop the spreading crisis (the Fed’s actions have been described as “desperate

improvisation”). (By the way, Ben Bernanke, the chairman of the Fed, is a scholarly

expert on the Great Depression; that is how he made his academic reputation as an

economics professor at Princeton. He argues – as do most other economists – that the

Fed could have avoided the Great Depression if it had acted more vigorously in the early

years of the depression. So Bernanke clearly does not want to make that mistake again.

How successful Bernanke’s more aggressive policies will be remains to be seen.) To

begin with, the Fed loosened the traditional monetary policies by lowering its target

short-term interest rate (the federal funds rate) from 5.25% to 2.0%, and also by lowering

the discount rate (the rate the Fed charges banks when the latter borrow from the Fed)

from 5.75% to 2.25%, both in a series of steps. The way loose monetary policies are

supposed to work is that they increase the funds that banks have available to loan out, in

the hopes that banks will respond by increasing their lending to businesses and

consumers, who will then invest and spend more. However, these traditional policies

have so far not been very effective, because banks have been unwilling to increase their

lending, both because they do not trust the creditworthiness of the borrowers and also

because the loss of capital that they have suffered (and will continue to suffer) requires

that they reduce their lending in order to maintain acceptable loan to capital ratios (as

discussed above). As the saying about monetary policy goes: “You can lead a horse to

water, but you can’t make it drink” (i.e. the Fed can provide more money to banks, but it

cannot make the banks loan this money out). Mortgage rates and other long-term interest

rates have risen over the last six months, in spite of the Fed’s reductions in short-term

interest rates.

        Because of this failure of traditional policies, the Fed began to improvise with

new policies, never used before. It made its discount loans to banks by auctions, closed

to the public, in order to remover the “stigma” attached to having to borrow from the Fed.

And it accepted mortgage-based securities (which are rated AAA, but are probably junk)

as collateral for its loans to banks for the first time (previously only Treasury bonds were

accepted). These changes have modestly increased bank borrowing from the Fed, but it

has not revived bank lending to businesses and consumers.

        But the most “revolutionary” of the Fed’s recent actions so far have had to do

with investment banks, the new kings of speculative finance, who are largely

responsible for the crisis in the first place. As mentioned above, investment banks are

largely unregulated, and the Fed in particular has no regulatory authority over investment

banks. Therefore, it has never been thought that the Fed had any responsibility to act as

“lender of last resort” to investment banks when they are in trouble. However, when the

investment bank Bear Stearns was on the verge of bankruptcy in late March, the Fed

decided that it had to act as lender of last resort to Bear Stearns and JPMorgan Chase,

which took over Bear Stearns.

        The Fed’s “last resort” loan persuaded JPMorgan Chase to accept the debts of

Bear Stearns. This was the crucial part of the deal, and the reason why the Fed

intervened. Bear Stearns was such a “wheeler-dealer” in speculative finance that it had

one of the highest debt to capital ratio of all the investment banks (reportedly 30:1). If

the debts of Bear Stearns had not been assumed by JPMorgan Chase, then the bankruptcy

of Bear Stearns would have meant that the lenders to Bear Stearns would have lost most

of their money. Since Bear Stearns was so heavily indebted to so many different

financial institutions, the losses would have been very widespread and could have

resulted in a complete “meltdown” of the US financial system – nobody lending money

to anybody for anything – and a disaster for the economy. That was the Bernanke’s

nightmare, and why the Fed intervened so quickly and decisively as lender of last resort

to these investment banks. The Fed justified its going beyond its traditional boundaries by

saying that “the financial system of the US was at risk.” The Fed’s statement and its

action are clear evidence of how fragile and unstable the US financial system is at the

present time.

       The Fed also generalized this policy by announcing that it would now allow

investment banks for the first time to borrow from its “discount window” on a regular

basis, and even to use mortgage-based securities as collateral for these loans, similar to

commercial banks. There is no legislative authority for this new Fed policy, but not

many people have criticized the Fed, because they think it is necessary because of the

crisis. The Fed hopes that investment banks will use these funds borrowed from the Fed

to get the wheels going again in the mortgage-based securities market. So far, this hasn’t

happened, because no one wants to buy mortgage-based securities anymore.

       By the way, the Fed’s generous acceptance of junk mortgage-based securities as

collateral for its loans to commercial banks and investment banks will probably end up

costing taxpayers money. The profits of the Fed are turned over annually to the US

Treasury. Losses on these mortgage-based securities would lower the Fed’s profit, which

in turn will reduce its annual contribution to the Treasury. The smaller contribution of

the Fed will have to be made up by a larger contribution from taxpayers.

       So far, the Fed’s unprecedented policies have been mildly successful, but by no

means a complete success. At least an all-out financial collapse has been averted (for

now). And “investor confidence” seems to have been restored somewhat by the

demonstrated commitment by the Fed to do everything it can to avoid a financial disaster.

However, commercial banks and investment banks have still not increased their lending.

And the Fed’s policies do not solve and cannot solve the fundamental problems of

declining housing prices and rising mortgage foreclosure rates.

       Going forward, the ability of the Fed to reduce interest rates still further will be

limited because its target rate of interest is already very low (2%) and therefore cannot be

reduced much more, and also because of its concerns about rising inflation and a falling

dollar (which also leads to higher inflation) (lower interest rates would tend to accelerate

both of those disturbing recent trends). Critics of the Fed argue that the Fed’s sharp

reductions in interest rates in recent months are at least partially responsible for both of

these worsening problem.

4.2 Congress

       Congress fairly quickly passed an “economic stimulus” bill of $168 billion in

February, that includes tax rebates for households and tax cuts for businesses. These tax

cuts will have some positive effect on the economy in the last half of 2008, but their

effect is likely to be small and temporary. At best, the tax rebates will provide a one-time

boost to consumer spending, since these rebates can be spent only once.

       Congress and President Bush have enacted various measures to try to slow down

the spreading foreclosures. All of these policies exclude speculators and apply only to

owner-occupied homes (everyone agrees on this point). The main policy of the Bush

administration is called “Hope Now”, in which the lenders voluntarily postpone the

“resets” of interest rates on subprime mortgages that are scheduled to take place in the

months ahead, and leave the principle of the loan unchanged (or sometimes the foregone

interest is added to the principle). The Bush administration claims that over 500,000

mortgages have been modified in this way in recent months, and estimates that another

500,000 mortgages will be modified in the months ahead. However, critics argue that

these numbers are exaggerated and that many of these modifications have been simply

allowing homeowners more time to make the same payments. It is likely that in the

months ahead, many of these homeowners still will not be able to make their payments,

and many of them will be foreclosed on. The only lasting solution is to reduce the

mortgage principle owed to more affordable levels. The main problem now is not the

reset of interest rates, but rather declining housing prices and negative equity.

       The House and Senate recently passed a law that does provide for a substantial

“writedown” of the principle of mortgages. This law allows for the replacement of

existing mortgages with new mortgages that would have a value of approximately 85% of

the current market value of the houses, and these refinanced mortgages would be

guaranteed by the Federal Housing Administration (how this “current market value” is to

be determined is a crucial detail which so far has not been specified). This 15% “write-

down” of the principle, plus the prior 10% decline of prices means that the total write-

down for lenders will be approximately 25%. The bill appropriates $300 billion for this

purpose, which it estimates could help as many as 1.5 million homeowners. However,

this refinancing must be initiated by the lenders (similar to the Bush policy) and is

opposed by the Mortgage Bankers Association. Therefore, it does not appear likely that

many lenders will initiate these writedowns, unless the mortgages are very bad.

       Another problem with this bill is that housing prices in some areas are likely to

fall more than an additional 15%. Mortgages on these houses are likely to be the ones

that the lenders will voluntarily refinance, and any further losses would have be borne by

the government (i.e. by the taxpayers). This would be a partial bailout of the lenders.

5. Policy recommendations for the Left

       How should the Left respond to this crisis? What principles and policies should

the Left recommend as solutions to this crisis? This final section first suggests immediate

policies to stop the foreclosures and evictions, and then suggests more long-run changes

that need to take place in the home mortgage market in the US.

5.1 Anti-foreclosure policies

       To begin with, there should be no bailout of mortgage lenders, neither by

Congress nor by the Fed. The lenders made fortunes on these risky mortgages during the

housing bubble, so if someone has to suffer losses now, it should be the lenders. This

includes Fannie Mae and Freddie Mac, who allegedly have an “unwritten and unspoken”

guarantee from the federal government to cover any and all of its losses. Since this

“guarantee” has neither been written or spoken, and is in fact explicitly denied in

legislation and on the securities themselves, this “guarantee” does not exist, and should

be ignored.

        Homeowners should be allowed to stay in their homes, either with affordable

mortgages or as tenants. Upon the request of homeowners, judges of foreclosures and

bankruptcies should be allowed to modify the terms of mortgages, either by reducing the

rate of interest or by reducing the principle, or both. Bills along these lines have been

introduced in the House (HR 3609) and the Senate (S 26360), and these bills are

supported by the AFL-CIO, SEIU, NAACP, ACORN, and many consumer protection

groups. These bills are of course strongly opposed by the Mortgage Bankers Association,

and they do not seem to have enough support for passage at the present time. This is the

kind of legislation that the Left should be supporting.

        Furthermore, homeowners should also have the option of staying in their homes

as tenants, rather than as owners, and pay the prevailing rent in the area (which is

generally much lower than mortgage payments). Such an “own-to-rent” plan has been

proposed by Dean Baker of the Center for Economic Policy Research, and a bill along

these lines has been recently introduced in the House.

        There should also be a one-year moratorium on foreclosures and evictions in

order to provide more time to work out appropriate policies to protect homeowners.

During the Great Depression, 26 states enacted moratoria on home mortgage foreclosures

for a period of 1 to 2 years, and these moratoria were upheld by the US Supreme Court in


       In addition, we should all participate in local anti-foreclosure and anti-eviction

struggles in our cities and towns, and try to link up these local struggles with wider

networks of resistance.

       In the long-run, the objective of government housing policy should be: decent

affordable housing for all.

5.2 Home mortgage market

       The mortgage crisis was caused by the nature of the current home mortgage

market in the US – filled with speculative finance and perverse incentives. If we want to

avoid similar crises in the future, this market has to be changed.

       At the very least, there should be much tighter regulation of the home mortgage

market and other financial markets. These tighter regulations should include: higher

lending standards, fixed rate mortgages only, maximum salaries for top executives, and

no securitization of mortgages, except perhaps by Fannie Mae and Freddie Mac of prime

“conforming” loans. In effect, we should essentially go back to the simple and stable

home mortgage market of the early postwar period. If “private label” securitization of

mortgages (i.e. by investment banks) is allowed to continue, the rating of mortgage-based

securities should be done by a government agency, not by private businesses. Beyond the

mortgage market per se, there should be no off-balance sheet entities (such as SIVs), and

investment banks and hedge funds (the “shadow banking system”) should be tightly

regulated, with higher capital requirements, similar to commercial banks.

       Finally thorough reconsideration should be given to the government provision of

home mortgages. Decent affordable housing is a basic economic right. There should

not be enormous profit made in the provision of credit for housing, as has been done in

recent years by investment banks and mortgage companies and hedge funds. Without

this huge profit, mortgages would be much cheaper and houses would be more

affordable. Therefore, the government should take over a significant share of the

important economic function of providing credit for housing.

        One possibility might be the renationalization of Fannie Mae and the

nationalization of Freddie Mac, but that would have to be carefully studied. There might

not be much left of Fannie Mae and Freddie Mac after their “implicit government

guarantee” is exposed as wishful thinking on the part of its creditors. And the

government should certainly not take over their bad mortgages, except at a heavily

discounted price. The total capital invested in both Fannie Mae and Freddie Mac

together is about $82 billion, which is about half the economic stimulus bill (tax cuts)

passed by Congress in February, and less than a third of the $300 billion appropriated for

the FHA refinancing bill discussed above, so the government purchase of these two

mortgage companies is certainly affordable. And it would provide much more and

longer-lasting benefits to the economy than these other policies.

        I hope that this paper will stimulate further discussion about what the Left’s

principles and policies should be in response to the mortgage crisis and the economic

crisis in general.


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