Credit Contagion

Credit problems have emerged in many other financial corners. Leveraged buyouts once financed by corporate bonds in the multibillion-dollar private equity boom of recent years are also in trouble. During the past weeks, prices on these loans have been falling, jeopardizing more than a half-trillion dollars of related securities. Banks are now having a hard time reselling these buyout loans and will have to write some of them off. The same is true of commercial mortgage-backed securities used to finance large office building projects. Estimated losses here again are in the tens of billions of dollars, and this market has virtually shut down.

The greatest area of concern, though, is falling prices in the biggest asset category in the U.S. economy—homes. The consumption binge of the last decade was, to some extent, a reflection of the housing market bubble that made it possible for homeowners to refinance their homes and free up over a trillion dollars. The binge suddenly reversed as house prices fell for the first time in decades last year. Estimates are that this decline will continue in 2008 and 2009 by as much as 10 percent each year. The derivative markets are predicting further declines of about 20 percent in home prices, which would wipe out some $5 trillion from the net worth of American households.

The feel-good factor for American consumers conferred by ever-rising home prices is now over. More and more homeowners are finding that they owe more on their mortgage than their house is worth. This negative equity is prompting many to walk from their mortgages and homes, making the debt the problem of the banks. As foreclosed homes get put on the market, it puts ever more downward pressure on home prices, which gives even more homeowners the incentive to walk.

Abandoned homes. If prices decrease by as much as 20 percent in 2008 and 2009, as Merrill Lynch estimates, this may mean that over 10 million American homeowners will have no equity left. No one knows what effect this will have on our national economy. The potential tidal wave of home foreclosures will throw many families into the streets, erode home values of other properties, and damage neighborhoods. There are some estimates that more than 2 million foreclosures could take place over the next two years.

What can public policy do under these circumstances?

The impact of the Federal Reserve is limited. The Fed cannot restore relaxed lending conditions or create mortgage rates that forestall defaults. Nor can it maintain today's unsustainable home prices. What the government must do is prevent hundreds of thousands of foreclosed homes from being thrown on the market, provoking an accelerated collapse of housing prices. The challenge is to find a way to help stressed families avert foreclosures by replacing mortgages that were in or near default with new ones that homeowners can afford. This can be done by following the precedent of the Great Depression, when a government agency bought up mortgages held by banks, traded them in for safe government bonds, and then issued new loans at lower rates to homeowners so they could afford to keep their homes. The government agency, called the Home Owners' Loan Corp., granted over a million mortgages, roughly 1 in every 5. Adjusted just for population growth, it would amount to 2.5 million mortgages today.

Alan Blinder, a former vice chairman of the Federal Reserve Board of Governors, recommends such an agency that would refinance only owner-occupied residences, leaving speculators to fend for themselves and excluding second homes and vacation homes, along with very expensive real estate. Also excluded would be mortgages where the borrower misrepresented himself—although Blinder recommends that cases of fraud or deception by the lender be treated generously. The lenders whose mortgages were bailed out would bear some of the cost by paying for half of the rate reduction the government would offer. Former Treasury Secretary Lawrence Summers also urges a focus on measures that will prevent unnecessary foreclosures by facilitating more-efficient settlements between homeowners and their creditors and thereby induce lenders to let families remain in their homes.