The Obama Administration is on track to nationalize the nation’s largest banks, unless it alters policy and creates a Bad Bank to absorb commercial banks’ mortgage-backed securities.
The housing market and banks are caught in a vicious cycle.
The market is glutted by builders with too many new homes, speculators unloading vacant houses, banks with repossessed properties, and homeowners seeking relief from mortgage commitments.
As housing prices fall, more homeowners with adjustable-rate-mortgages cannot refinance when their rates reset, and others, simply discouraged, default. Supply increases again, perpetuating the spiral of falling home values, mortgage defaults, and bank losses on mortgage-backed securities.
To cover losses, banks should raise new private capital by selling additional stock. But investors, seeing no end to falling home prices and bank losses, have pushed down share prices to levels making it impractical for banks to raise capital.
The TARP has aggravated the problem.
When first approved by Congress, Treasury was to buy mortgage-backed securities from the banks, but it ultimately determined it was not possible to assess their values. Instead, Treasury used TARP to inject capital into banks, purchasing warrants convertible to bank shares, and left banks to work out their problems.
As losses mounted, so did Treasury’s equity stake and involvement at Bank of America, Citigroup and several other banks. Many investors fear sweeping nationalization is inevitable, and have become even more reluctant to purchase bank stocks.
Those fears will continue until the mortgage-backed securities are removed from the banks’ balance sheets or their potential damage neutralized. However, Treasury Secretary Geithner’s proposal to create a public-private investment fund to value these assets and mitigate their consequences is vague and hauntingly reminiscent of the strategy the original TARP was forced to abandon.
As housing prices fall, the banks will have no place to go but the government for the capital to cover losses, and their ownership will pass into government hands, first Citigroup and then others.
Economists, whether employed by banks or the Treasury, cannot reasonably estimate the ultimate value of mortgage-backed securities and the losses banks will take until the number of defaults and foreclosures is known, and that is the trap that snares the market.
The number of foreclosures cannot be divined without knowing how far housing prices will fall, and the drop in housing values cannot be estimated without knowing the number of defaults and how many houses will be dumped onto the market.
A federally sponsored “bad bank,” or “aggregator bank” could purchase all of the mortgage backed securities from commercial banks at their current market-to-market values on the books of the banks. It could determine the number of defaults by performing triage on mortgages—deciding which homeowners if left alone will pay their mortgages, which if offered lower interest rates and moderate principal write downs could reasonably service new loans, and which must be left to fail.
Implementing those standards and necessary mortgage modifications across the entire market would, at once, limit the number of defaults and determine how much housing prices will ultimately fall. That is something the individual banks cannot accomplish acting independently.
The Bad Bank could be capitalized with $250 billion from the TARP, and it could raise additional capital by selling $250 billion in shares, and another $500 billion to $1 trillion by issuing bonds. The commercial banks could be paid for their securities with 25 percent in shares and the rest in cash.
By sweeping all the mortgage-backed securities off the books of the banks and limiting losses on those securities, the Bad Bank would earn money collect payments on the majority of mortgages that ultimately pay out and sell off repossessed properties at a measured pace. Like the Savings and Loan Crisis Resolution Trust, and the Depression- era Home Owners’ Loan Corporation, it would likely make a profit.
Relieved of the mortgage backed securities, the banks would not be trouble free—they still have auto loans and credit card debt to repent. However, having huge deposits and vast networks of branches, they would be worth a lot to investors again, and could raise new capital, repay their TARP contributions and write new mortgages.
The bankers could then go on their merry way, until a few decades hence, they once again determine their salaries should support the lifestyles of rock stars and create financial products to pay them.
My son plans to study finance. He can solve that crisis.
PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.