Paulson’s Latest Egg
[For comment on what may be a waste of $350 billion in rescue money, click here.]
Today the Wall Street Journal reported [subscription required] the outlines of a new plan by Treasury chief Paulson to help stabilize the housing market. Under the plan, Treasury would buy securities that package “new home loans” guaranteed by Fannie and Freddie. The report did not estimate the amount of money potentially involved.
This plan (or at least the WSJ's report on it) has one ambiguity, two possible advantages, and seven decisive disadvantages.
The ambiguity lies in the words “new home loans.” Do these words mean: (1) any new loans for homes, including refinancings, (2) new loans for any new purchases, including those of existing homes, or (3) loans to purchase newly built homes only?
Resolution of this ambiguity will determine whether and how much (if at all) the plan would stimulate the general economy. Unless we want to continue spending trillions haphazardly, we must make sure that every expenditure does double duty. It must stimulate the general economy at the same time as it stabilizes our financial sector. With $2 trillion already spent and more than $ 7 trillion guaranteed, we don’t have enough trillions left to borrow to do one thing at a time.
Including refinancings in the new Paulson plan would be a bad idea. They generate no new economic activity outside the financial sector and so provide no general economic stimulus. Including resales of existing homes would be better, but not much. Resales directly promote economic activity (the loan itself and any subsequent securitization) only in our financial sector. They might promote some other economic activity incidentally, for example, by making it easier for workers to sell their homes and seek better jobs in new locales. But that’s not enough double duty to justify the program.
By far the best option would be to limit the program to newly built homes. Doing so would help our home-construction industry recover directly by rapidly clearing the huge inventory of unsold new homes.
Two possible advantages accrue to this plan, but only if it excludes refinancings. First, the program might help stabilize housing prices by making it easier (and perhaps cheaper) to buy and sell homes. Second, if limited to new construction, it might stimulate the home-construction industry, but not until after clearing most or all of the currently unsold inventory.
Against these possible advantages, the program as reported would have all seven disadvantages of the $800 billion new bailout plan that Paulson floated over the Thanksgiving holiday. First, it would contradict Paulson’s own recent experience, which led him to “inject capital” into failing financial institutions rather than buy complex toxic paper. Second, to the extent private institutions originated the loans to be securitized and bought with federal funds, the plan would leave the same people who brought us this mess in charge of the loans’ and securities’ terms. Third, in so doing, it would encourage (or at least not discourage), additional risky, stupid and predatory behavior, making moral hazard official government policy.
Fourth, Paulson’s new program is an invitation to step into the same pitfall that Paulson only recently avoided by not buying “troubled” paper under the TARP program. Packaged-loan securities and their derivatives are impossible to price accurately because their markets are completely opaque, with no relevant readily available data. Moreover, existing mathematical risk-assessment models are garbage: they assume away the most salient risks.
Fifth, the program would build our securitization/credit-swap/derivatives house of cards even higher, without additional regulation, even though every rational commentator has identified lack of regulation as what made those markets fail. It would be easier, simpler and safer to have Fannie and Freddie inject the money directly into mortgage loans and put the securitization-derivatives markets on hold until they can be rationalized and made safe and sound.
Sixth, the program assumes that tightness of credit, or its price, is the cause of the slowdown in housing, rather than the continuing free fall in housing prices and the natural caution induced by general economic conditions. There is no evidence, other than anecdotes, for that assumption. Finally, whatever money Paulson & Co. pumps into this program before January 20 will be unavailable for the incoming administration to use for its own economic recovery program.
The crux of the matter is Paulson’s fixation with post-loan financial markets, i.e., securities that package loans and their derivatives. These are the “products” of Wall Street. Lest we forget, they are also the products that caused our current financial meltdown because the markets in which they trade are completely opaque, unregulated and chaotic.
By continuing to rely on these failed markets with no new government supervision and no new regulation, Paulson threatens to throw good money after bad. Why anyone would want to pour more money into markets whose failure is the root cause of all our immediate problems is puzzling.
The new program might make more sense if Fannie and Freddie themselves set standard, sensible, nonpredatory terms for new mortgages, purchased them, and securitized them itself. But those precautions are not features of the program as reported. Evidently Paulson wants to have the (so far falsely) presumed advantages of derivatives markets in “recycling” loan capital without doing the hard work of stabilizing, rationalizing and regulating those markets, which might take years.
At this point, Paulson & Company seem like exhausted, punch-drunk knights in old movies of medieval jousting. They are so tired they can barely raise their lances. They are members of an administration that was out of useful ideas when it took office eight years ago. More important, their expertise is limited to the Wall Street branch of our financial sector―an important part, but only a small part, of our huge economy.
That expertise is far too narrow to fix our economy as a whole. We need industrialists and at least a few scientists on our recovery team, plus some plain old-fashioned bankers of the non-Wall-Street variety.
We need to recall that banking (the more so investment banking) is economic infrastructure, not the economy. And it’s our entire economy that, according to yesterday’s official report, has been in recession for a year.
But help is on the way. The Obama administration includes some of the best economic minds in the nation. It will have had two months―with no direct responsibility and no need to fight alligators―to take the measure of our economic swamp and chart a way out. It will also (I hope) include a few industrialists and scientists, so that real industry and basic research will not be neglected in the recovery plan. No plan can begin to fix our economy, or even do serious double duty, unless it addresses real industries that make real things.
The best thing that Paulson & Company can do now is stop trying to invent grand new initiatives and settle into a holding pattern until January 20. Their efforts to stabilize credit markets appear to have had some success. The Libor (London Interbank Offered Rate) has dropped from 4.5% at the height of the credit crisis to 2.2%. That’s progress.
Paulson & Company should take comfort in that fact and continue, as cheaply as possible, to do what appears essential to keep credit markets from refreezing. That’s where their expertise lies, and that’s the only respect in which they have had demonstrable success so far.
General economic recovery requires much more. It must involve housing, industry, infrastructure, education and basic science. And if our auto industry and remaining heavy industry are to have a ghost of a chance of long-term survival under American ownership, it must involve rapid reform of health care as well.
All these things are jobs for the next administration, which has no restrictive ideology, fresh horses, and much broader expertise. Most important of all, it has a new architect in chief, elected for his wide strategic vision. That is something the present administration doesn’t have and never had, however smart its Wall Street investment bankers may be within their narrow fields of expertise.
UPDATE: IS $350 BILLION BEING WASTED? In a story posted late today, the New York Times suggested that the loan-securities purchases by Treasury discussed above are part of the $800 billion bailout announced last week and criticized in my earlier post. According to today’s Times story, that bailout allotted $500 billion to purchases of mortgage-backed securities. Based on figures it reported for last week, almost 70% of the new loan money, or about $350 billion, would go for refinancings.
This information leads to three questions. First, what good will $350 billion of refinancings do for the real economy? People like me who have good credit will be able to reduce their monthly payments, but this money will do nothing to increase sales of homes, help homeowners in default or foreclosure, or encourage new home construction. Second, how can newspapers last week have reported $600 billion allotted to the mortgage industry, while a reputable paper like the Times now reports $500 billion? Was the difference just a reporter’s a typo, or is Treasury now so under stress and chaotic that it doesn't even notice an $100 billion discrepancy any more?
These questions suggest that Congress should call a halt to further bailout activity by Treasury until Treasury files a full report of expenditures so far and Congress has had time to digest that report. It would be hard to conceive of a less productive means of spending $350 billion in economic rescue money than allowing millions of people with good credit and no risk of default to refinance their homes. All that would do if shuffle paper and generate yet more opaque and risky mortgage-backed securities and their derivatives.