Wall Street Embraces Government to Avoid Recession
With U.S. mortgage foreclosures set
to top 1 million this year and home prices falling at the
fastest pace since the Great Depression, Lehman Brothers
Holdings Inc. Vice Chairman Thomas Russo says the government
must take action to prevent a recession.
“The direction we are heading in isnt a good one, Russo
said in an interview. “We need significant fiscal and monetary
intervention.
The worst drop in new home sales on record has turned
financial leaders into champions of big government with everyone
from Russo to executives at Citigroup Inc. and JPMorgan Chase %26amp;
Co. supporting public measures to keep the housing market from
sinking the economy. Its a change from Wall Streets usual
stance that markets work best without government interference.
“Sentiment can change when theres money on the line, even
in an industry that up to now has been doctrinally opposed to
government having a role in the markets, said Thomas
Schelling, a Nobel laureate in economics who taught at Harvard
University for 30 years.
Wall Street fueled the growth of subprime lending by
packaging home loans into securities and marketing them as low-
risk investments. As demand rose, lending standards dropped,
driving the homeownership rate to an all-time high of 69.2
percent in 2004. The median U.S. home price reached a record
$230,200 in July 2006. Last month it was $208,400.
Countrywides Loss
Now, many of the same people who profited by putting buyers
into properties they couldnt afford are advocating federal help
to manage the bust.
Their demands were answered this week when the House and
the Senate Finance Committee approved economic stimulus plans
worth $146 billion to $157 billion. The Senate version includes
a tax break for banks and lenders. Losses from investments in
subprime mortgages may total as much as $400 billion worldwide,
Deutsche Bank AG said in November.
Angelo Mozilo, chief executive officer of Countrywide
Financial Corp., supports the governments Hope Now program, a
coalition of mortgage companies aimed at preventing foreclosures
by freezing adjustable rates or refinancing loans of subprime
borrowers.
That type of loan increased Countrywides net income to
almost $2.7 billion in 2006 when it was the biggest U.S.
subprime lender. Mozilo earned $48 million that year.
Countrywide reported a net loss of $703.5 million in 2007,
dragged down by loans to people with bad credit, and the
Calabasas, California-based company agreed Jan. 11 to be
acquired by Charlotte, North Carolina-based Bank of America
Corp. for about $4 billion.
`Amazing Hit
Hope Now is being pushed by Treasury Secretary Henry
Paulson, former chairman of Goldman Sachs Group Inc., and backed
by firms such as New York-based Citigroup, led by Chief
Executive Officer Vikram Pandit, and JPMorgan, headed by CEO
Jamie Dimon.
In addition, the government expanded Federal Housing
Administration mortgage funding in August to help subprime
borrowers and President George W. Bush has proposed using tax-
exempt bonds to refinance mortgages. Those programs wont help
homeowners who have seen their property values drop below their
loan balances.
The measures arent enough, Russo said.
“The whole financial system has taken an amazing hit
already and the bulk of the mortgage rate resets are still to
come, Russo, 64, said.
Without additional government action, declining home values
will prompt people to snap their wallets shut, choking the 70
percent of the economy thats driven by consumer spending, Russo
said in a paper he presented at the World Economic Forum in
Davos, Switzerland, last week. Russo said the paper reflected
his own views and analysis, not those of New York-based Lehman,
the fourth-biggest U.S. securities firm by market value.
Russos Proposals
About $550 billion of subprime loans will reset before
2009, Russo said. Most of those borrowers will have no option
except to walk away from their properties because the drop in
home prices and an increase in lending standards will prevent
them from refinancing or selling, he said.
Russo, in the paper originally written for the Group of
Thirty, a research group led by former Federal Reserve Chairman
Paul Volcker, proposes giving government-backed loans to
homeowners with adjustable-rate mortgages, whether prime or
subprime, in danger of default. He also supports a tax credit
for people who buy homes in 2008 that would roughly triple the
current tax benefits given to mortgage holders.
In addition, the Federal Reserve needs to cut its benchmark
rate to 2 percent, reduce the discount rate to match it, and
“broaden access to the discount window where banks get
government-subsidized temporary loans, he said. The Fed lowered
the benchmark interest rate to 3 percent on Jan. 30, the second
cut in nine days.
Quick Action
Those measures surpass the Hope Now program and the
stimulus plans that passed this week. A provision in the House
measure would temporarily increase in the size of loans that can
be bought by Fannie Mae and Freddie Mac, the largest U.S.
mortgage-finance companies.
“To be useful, a fiscal stimulus package should be
implemented quickly and structured so that its effects on
aggregate spending are felt as much as possible within the next
12 months or so, Fed Chairman Ben Bernanke said in Jan. 17
testimony to Congress.
In backing government action, Bernanke broke from the creed
of Milton Friedman, the free-market champion who said such
programs dont work. Bernanke described Friedman in a 2002
speech as the man who inspired his interest in monetary policy
when he was a college student.
While top regulators and executives are demanding help,
some of their colleagues are shaking their heads in disbelief.
Mark Kiesel of Pacific Investment Management Co., the
worlds largest bond fund manager, said rescuing borrowers will
worsen the economic misery for everyone. Kiesel helps oversee
more than $700 billion of fixed-income investments at Pimco.
`Blunt Instrument
“Keeping the market from correcting itself only prolongs
the problem, he said. “It helps a couple hundred thousand
people stay in their homes a little longer, but it also may have
the unintended consequence of lifting mortgage rates for
everyone because if youre going to be changing the rules,
investors will need to be compensated for that risk.
David Henderson, an economist at the Hoover Institution at
Stanford University in Stanford, California, agrees.
“Government intervention is a blunt instrument aimed at a
particular problem that ends up hitting all of us, Henderson
said. “Let the housing problem work itself out.
The camp that favors government action is growing.
Growing Group
“We look forward to continuing our work with the
administration, Congress, state and local officials to limit
the number of foreclosures, Washington Mutuals Schneider said
in a statement last month in support of the Hope Now program.
The Seattle-based company, the largest U.S. savings and loan, on
Jan. 17 reported a fourth-quarter loss of $1.87 billion after
writing down the value of its home mortgage unit.
Alex Pollock, former president of the Federal Home Loan
Bank of Chicago, urges the creation of a federal lending agency
based on the Home Owners Loan Corp., or HOLC, created by
Congress during the Great Depression.
Robert Kuttner, co-founder of the Washington-based Economic
Policy Institute, Senate Banking Committee Chairman Christopher
Dodd and others have proposed similar ideas.
Many who are calling for action point to the 1930s, the
last time the U.S. national median home price fell, as an
example of what government should do.
Great Depression
During the worst economic slump of the 20th century, HOLC
issued tax-exempt bonds and used the proceeds for below-market-
rate mortgages. It refinanced one-fifth of U.S. homes between
1933 and 1936 after negotiating with the original lenders to
accept less than the amount owed on the defaulted mortgage.
Former Treasury Secretary Edward Carter Glass opposed
President Franklin D. Roosevelts expansion of government after
the 1929 stock market crash. Senator Robert Taft, a critic, said
it was socialism. Most Americans supported Roosevelt and his
“New Deal plan. He won every state except Maine and Vermont
when he ran for re-election in 1936.
In the 1930s, lenders were seizing homes at an average rate
of 3,000 a day, adjusted for todays housing stock size. In the
fourth quarter of 2007, new foreclosures averaged 2,939 a day,
double the pace of a year earlier, according to RealtyTrac Inc.,
an Irvine, California-based real estate data company.
Statistics like these are managing to change even the most
ardent opponents of big government. William McCarthy, a mortgage
broker in Parker, Colorado, said he has been against federal
intervention his entire life. Now 62 and facing eviction Feb. 11
after his lender foreclosed on his $199,200 mortgage, he said
the government has to take action.
Suicides and Bankruptcy
“This has reached the point of being catastrophic, said
McCarthy, who declared bankruptcy in July when his business
failed after 18 years. “I had a client who called me sobbing
because his wife committed suicide rather than face eviction.
Somethings got to be done to help people.
McCarthy said he took an interest-only adjustable-rate
mortgage in 2005 when he and his wife, Janna, bought a 1,680-
square-foot, ranch-style retirement home in Littleton, Colorado.
His wife has a heart condition and needs a home without stairs,
McCarthy said. They planned to sell their primary residence and
refinance the ranchs interest-only loan before it reset, he
said.
Risk Taking
They didnt act fast enough. In March 2006, U.S. home sales
began the biggest decline in 26 years, according to data
compiled by the Chicago-based National Association of Realtors.
The house didnt sell. Now, they are losing both properties.
“My wife goes to bed crying every night, and theres
nothing I can do, McCarthy said. “The bank wont even return
my calls.
Bailing out borrowers who take risks creates a “moral
hazard that leads to riskier behavior as people assume the
government will step in to save them, said Kiesel. In March 2006
Kiesel sold his house near Pimcos headquarters in Newport
Beach, California, and rented a home in anticipation of the
housing slump.
“The housing market will find its own bottom, without a
government bailout, Kiesel said.
