Fed's suggestion reflects crisis
Stephen Ellis

Nothing more emphatically underscores the danger to the US economy from the housing meltdown than Tuesday's suggestion by Federal Reserve chief Ben Bernanke that lenders may have to reduce outstanding principal owed to them by borrowers with negative equity in their homes.

When the Fed chief suggests that lenders shouldn't ask - or expect - to be repaid in full, it is a pretty clear signal there is a major economic problem with no simple or inexpensive fix.

The mess in the US housing market, where prices have already fallen (by a few percentage points according to optimists and something closer to 10 per cent according to pessimists), and foreclosures are estimated to swell to 3 million by 2009, is just such a problem.

Not only does housing account for half the accumulated wealth of US households, making movements in housing prices an important determinant of consumer confidence and spending, it is also a peculiar market that behaves in less predictable ways over more uncertain time horizons than most of the economy.

As the sub-prime mortgage crisis illustrates, the dominant role of home mortgages - many of them now understood to be riskier than investors had assumed - in the asset pooling and securitisation machine that underwrote Wall Street's post-2002 boom means that changes in prices or consumer behaviour in the housing market immediately affect the entire financial system.

Against this background, Bernanke pointedly noted that eventual aggregate returns to lenders may be best served by taking a haircut on loan principal, given the swelling number of US borrowers with no equity stake in their properties who are simply walking away from their obligations.

This is triggering huge losses for lenders (including the owners of mortgage-backed securities) since these homes are typically worth less than the outstanding loans, even before the costs of foreclosing on them, which frequently run as high as six figures - a substantial portion of the remaining value of the mortgage.

"Although lenders and servicers have scaled up their efforts and adopted a wide variety of loss mitigation techniques, more can, and should, be done," Bernanke said, suggesting this should include calculating the economics of forgiving part of the loaned amount.

"When the mortgage is underwater, a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure." Bernanke's comments are the clearest indication yet of how deeply concerned the Fed is by the housing market meltdown.

These concerns extend well beyond the more contained problem of the 6 million or so US home owners with sub-prime mortgages, up to half of which may eventually become foreclosure candidates, and which have been the sole focus so far of the Bush administration's response to the crisis.

Sub-prime foreclosures are triggering a more generalised fall in housing prices, particularly in regional markets where home ownership rose most rapidly in recent years, such as Arizona, Nevada, southern California, Ohio, parts of the Carolinas and parts of Florida.

These, in turn, are prompting more underwater home owners to simply abandon their mortgage-encumbered homes and take shelter behind the relatively generous US bankruptcy laws.

Bernanke's suggestion - which was for the financial services industry to act voluntarily, and in no way a call for any compulsion or direct government interventions - is controversial because to work it would involve negotiation among many parties.

Because most US mortgages are written, administered (or serviced), insured and ultimately owned, by completely unrelated parties with conflicting interests, any write-down in principle would require intricate legal arrangements and the consent of multiple entities. These would include the owners of bonds backed by pools of securitised mortgages.

The multiple layers, principal-agent issues and the sheer mathematical complexity of deciding who loses what, make renegotiation of the principle due on a home loan far more difficult in many cases than an analogous restructuring or workout of a distressed corporate borrower.

As the comments make clear, for the Fed at least, a less dysfunctional housing market and mitigation of the downward spiral (in which foreclosures generate further price falls, which in turn create a new cycle of abandoned mortgages and foreclosures) is worth the challenge and complexity of the institutional arrangements.

Bernanke's comments stand in contrast to recent rhetoric from Treasury secretary Hank Paulson, who has so far baulked at anything that has the whiff of a generalised concession by lenders to borrowers.

Paulson, correctly, is concerned about moral hazard - the distortions that arise when economic actors are allowed to escape some of the risks of their actions - and so far has remained focused on the narrower issue of sub-prime lending.

He appears to feel that it is bad enough for the government to have been forced to step in and help (at the margin) some sub-prime borrowers who took out mortgages they may turn out to be unable to afford as they become more costly.

Bernanke's suggestion creates a whole new set of similar issues, since it basically amounts to lenders releasing borrowers from their obligations (albeit only where this makes economic sense for the lender).

It seems fair to assume that the much larger moral hazard that Bernanke is trying to mitigate, by encouraging a more targeted and economically effective alternative, is the hazard that has arisen from the Fed being forced to slash interest rates to protect the financial system from the consequences of its own choices and actions.

Not only has this put the Fed in the difficult position that it has had to set aside any medium-term inflationary concerns and respond to the panicky markets with rate cuts that at times have looked equally panicky, but it has also addressed the housing and mortgage lending mess with the bluntest of instruments.

Encouraging lenders to be more flexible and intelligent in calculating what is in their own best interests, even when this defies conventional thinking, is a far preferable course.

Whether anyone will take the advice (and if they do, whether they can make it work in practice) is for now less clear-cut.

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