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US: What will fix the mortgage mess?

Too many proposals are impractical, or worse. Is there anything that can cushion the economy from the hit of the subprime crisis?

With the credit markets in turmoil and housing prices tumbling, people from Wall Street to Main Street are wondering what can and should be done to minimize the damage to the broader economy. Should the Federal Reserve do more to bring confidence back to the markets? Should state legislatures take action to prevent a wave of local foreclosures? One of the most radical proposals came from Bill Gross, the bond guru at Allianz’s (AZ) Pimco, who is calling for a federal bailout for homeowners. “Write some checks, bail ’em out, prevent a destructive housing deflation that [Fed Chairman] Ben Bernanke is unable to,” says Gross. “If we can bail out Chrysler, why can’t we support the American homeowner?”
But forget grand gestures. The sweeping proposals being floated are better suited for grabbing headlines than for rectifying the current problems. They tend to be politically unfeasible, unwieldy, or simply foolish. Consider for a moment talk of a possible taxpayer-funded bailout for Countrywide Financial (CFC) and New Century Financial (NEWCQ)— the same subprime lenders that helped fuel the credit bubble.
Then there are those who think government-sponsored mortgage buyers Fannie Mae (FNM) and Freddie Mac (FRE) can save the entire US housing system from ruin. Only in Washington is it hard to understand that profit-driven, shareholder-owned corporations won’t be willing buyers of clearly bad investments.

“Let the market cleanse itself”
Speed and pragmatism are what’s needed now. The Fed can certainly make a difference by lowering interest rates, in addition to the cut in the discount rate it’s already made. State agencies are probably the best positioned to protect homeowners who have truly been the victims of predatory lending. And proposals to crack down on abusive mortgage practices and increase disclosures for borrowers are good safeguards to consider for the future. But foreclosures—widespread foreclosures—are inevitable. The days of easy money meant that many people borrowed much more than they could afford—and keeping them in their dream houses will only penalize other taxpayers and encourage more uncontrolled borrowing in the future. Risk, as Wall Street veterans like to point out, can be risky. “It’s sometimes better to let the market cleanse itself out,” says Kathleen Camilli, a member of the National Association of Business Economics.

Hot campaign issue
The housing crisis promises to be a major presidential campaign issue in the weeks and months ahead. During the Democratic debate on Aug. 19, no candidate was short of ideas or hesitant to assign blame. Senator Joe Biden (D-Del.) said there should be more transparency among hedge funds and private equity firms, saying “they are the ones that are causing this thing to go under.” Former Senator John Edwards (D-N.C.) called for a "home rescue fund" for borrowers at risk of foreclosure. Senator Christopher Dodd (D-Conn.), the Senate Banking Committee chairman, urged the Fed to cut interest rates more aggressively and asked the Bush Administration to loosen regulatory control over Fannie Mae and Freddie Mac.
Wall Street’s senators, Hillary Clinton (D-N.Y.) and Charles Schumer (D-N.Y.), are among the loudest voices on Capitol Hill calling for federal aide for homeowners. Schumer said that news on Aug. 27 showing a 9% drop over 12 months in existing home sales in July was “another in a series of daily reminders that more must be done to prevent the subprime mortgage market from further damaging the housing market and broader economy.” Schumer is pushing for a change in accounting rules that would allow banks to modify loan terms for at-risk borrowers without the usual penalties required under generally accepted accounting rules. He has also inserted $100 million into the Housing Dept. budget bill to fund nonprofit groups such as ACORN that provide free credit counseling and foreclosure assistance to low-income borrowers.
Clinton has made preserving the “American dream” a key component of her campaign, calling for $1 billion for state and local housing agencies to help at-risk borrowers avoid foreclosure. She’s also drafting legislation to rein in mortgage brokers, requiring state licensing and federal registration.

Holding Wall Street accountable
Those outside the Beltway have more aggressive proposals. “None of the proposals that are being offered address what was the root cause of the problem and it is likely to reoccur,” says Lynn Turner, the former chief accountant at the Securities & Exchange Commission.
“Wall Street played a major role here and made a ton of money. Why aren't the Dems questioning Wall Street?”
Turner says many of the same problems that allowed the credit rating agencies to miss Enron’s collapse weren’t corrected when Congress gave the SEC some authority to monitor the industry. “The legislation that passed last year is so weak. There’s very, very little oversight,” Turner says. (One of the largest credit rating agencies, Standard & Poor’s, is owned by The McGraw-Hill Companies (MHP), which also owns BusinessWeek.) Turner also says Congress should require better disclosures from bond issuers and tighter lending standards from bank regulators.
Senators Clinton, Schumer, and Dodd have also called on the Administration to lift a regulatory cap on Fannie Mae's and Freddie Mae's growth that has essentially handicapped their ability to invest in the market right now. The Bush Administration and the companies' regulator, the Office of Federal Housing Enterprise Oversight, have rejected requests to lift their portfolio caps until Fannie and Freddie correct material deficiencies in their internal controls and bring their securities disclosures current. After more than three years of earnings restatements and accounting revisions by both companies, that isn't expected to happen until next year at the earliest.
Although the two companies are big—owning or guaranteeing roughly half of all US residential mortgages outstanding—they aren’t big enough to finance an industrywide rescue plan. Plus they both have their own balance sheets to worry about and accounting troubles to work through. The proposals getting the most serious attention in Washington would only briefly lift their portfolio caps and would restrict their additional purchases to somewhere under $100 billion apiece—not much liquidity in a $10 trillion market. By law, Fannie and Freddie also are prohibited from investing in the so-called jumbo loan market, which is reassessed every year and is currently confined to loans over $417,000. Some lawmakers, including Dodd, have backed legislative plans granting them entry into the jumbo market—even though a bulk of the defaults are stemming from smaller loans.

Too little, too late
For the most vulnerable homeowners at the greatest risk of losing their homes, there’s little chance Congress can act in time to help them. “It is traditionally the case that by the time the government acts, the problem has already passed as a crisis,” says Doug Duncan, chief economist at the Mortgage Bankers Assn. And many of the proposals politicians are touting as rescue plans wouldn’t save some homeowners, no matter how quickly they were enacted. The foreclosure rescue programs Senators Clinton and Schumer want to finance with taxpayer money won’t actually rescue borrowers from imminent foreclosure.
State housing officials say many of those borrowers are too far behind on their payments, don’t have enough equity in their homes to justify helping, or never had enough income to qualify for a loan in the first place. That’s why state officials are instead focusing on people who are not yet behind on their payments but could be at risk once their interest rates are adjusted. “It was never intended to be a foreclosure rescue program,” says Joel Ghitman, director of homeownership for the Ohio Finance Agency, which was the first state agency to roll out a refinance program for at-risk borrowers earlier this summer. The agency is working with Fannie Mae to provide an initial round of $100 million in subsidized financing to homeowners in high-cost loans. “If somebody is already headed down the path of foreclosure, they will be unable to participate in the program and I don't know if anyone will be able to help them. The whole emphasis is to help these borrowers before they get too deeply in trouble.”

Many economists believe that bailouts usually are not the best solution. “Our focus is on liquidity, not a bailout,” says the MBA’s Duncan. A bailout creates its own problems, he says: “You’re going to change behavior in the marketplace in ways you hadn’t foreseen.” (