Washington, D.C.–At a Brookings seminar today, leading economists recommended measures to address the foreclosure crisis that has led to widespread credit market turmoil. 

Former Treasury Secretary Lawrence Summers said that the evidence is overwhelming that the American economy is already in recession.  The only questions are how serious and prolonged the recession will be.

He argued that three mutually supporting vicious cycles are operating:  1) a liquidation crisis in which prices fall, putting certain asset holders under pressure to sell, even as demand falls, causing prices to decline further; 2) a Keynesian phenomenon of reduced spending that leads to reduced income, which in turn leads to reduced spending; and 3) a “credit accelerator” in which a weak economy leads to less lending, which leads in turn to financial distress, further weakening the economy.  He warned that a fourth vicious cycle could occur whereby falling housing prices would lead to more foreclosures, putting more housing on the market, leading to a decline in housing prices. 

Housing prices are likely to decline another 15%, Summers noted, meaning that up to 15 million mortgage-holders could have negative equity (property worth less than the mortgage balance), which in turn could lead to 2-3 million or more foreclosures.  He stressed that foreclosure itself is very expensive, costing 40% or more of the value of a house.  So minimizing the numbers of foreclosures makes sense.

Former Treasury Secretary Robert Rubin remarked that the risk to other financial markets and the economy at large had become sufficiently great that we should be acting in a very serious way.  He questioned whether measures without substantial public funds would suffice.  The political system has not yet got the right sense of urgency to do serious problem solving, he added. 

Michael Barr of the University of Michigan discussed a SAFE loan plan that would imitate the Home Owners’ Loan Corporation (HOLC) of the Great Depression.  SAFE would:  1) transfer a pool of distressed mortgages by auction to new lenders at steep discount; 2) restructure loans on affordable terms; and 3) provide funds to nonprofits and others to deal with local issues.  Using the private market, he said, would be faster, easier, and more efficient than relying on the government as buyer.  Private buyers are better judges of value.  The Treasury and Federal Reserve could provide a transparent platform for these auctions. 

One objection to this approach was voiced:  that private buyers will not have sufficiently high profit prospects to buy, so the auction will not work. 

Douglas Elmendorf of Brookings made five prescriptions:  1) support mortgage counseling; 2) write down principal, a more effective approach than foreclosure; 3) provide funding to states and localities to help; 4) adjust bankruptcy law to permit write-downs of some mortgages; and 5) expand eligibility for FHA funding, limited to those who actually have made payments.  All speakers agreed that it made no sense to support investor-owned mortgages or homeowners who would never pay mortgages.

Elmendorf pointed to the complication of second mortgages, often with a different lienholder.  One-third to one-half of subprime mortgages have second mortgages.  According to Barr, second mortgage holders were already wiped out, so it made sense to engage in a “cramdown” that would oblige them to accept a small payoff.  Summers commented that second lienholders are in a strong position to hold up restructuring, so the problem becomes how to oblige them to say yes.  

Marguerite Sheehan of JPMorgan Chase observed that we still have a long way to go before resolving the subprime problem.  She saw a need for a standard methodology for determining who is deserving of a write-down in order better to evaluate portfolios.  Principal reduction is not an industry standard.  It is easy to deal directly with a customer, she commented, but everything becomes more complex with a third party such as the government.   

Kenneth Wade, CEO of NeighborWorks America, argued that we need to ascertain the income of the consumers, today’s value of the property, and the presence of fraud.  There is a rising inventory of previously foreclosed properties, and we need to find ways to bid on them. 

Summers noted that 50% of those foreclosed resist all contact.  Some are investors, not “owner-occupied”.  Wade responded that a small portion involves fraud; but many owner-occupiers are alienated by collectors and behind in consumer debt.  Others want to work it out on their own, are in denial, or fear that contact with lenders will accelerate foreclosure.  Pre-purchase counseling has been shown to work for low-income people, he said.

To a question of whether we haven’t been too focussed on home-ownership, whereas for many people a modest rental makes more sense, Summers responded by saying “we may have tilted the playing field too far in favor of ownership.” He thought that we could recycle some of the previously foreclosed property inventory into rentals.

Elmendorf argued that we need to take a new look at securitization in general.  Securitization lacks a mechanism to deal with problems like unpayable debts, and in a sense it has created greater risk rather than spreading it and thereby making it more manageable.

In conclusion, Summers asked whether the subprime mortgage problem is the central question now or whether other credit issues have surpassed it.  It would be a mistake to think that funding foreclosures will solve the larger issues, he said.

Kenneth J. Dillon 


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