Get Ready for a Second Obama Economic Stimulus Program

The queen of England asked a good question: "Why did no one see this coming?" She was talking, of course, about the world financial crisis. The answer is that nothing like this has ever happened before. Totally unprecedented, it was therefore unpredictable.

Mort Zuckerman

It came upon us at the speed of an avalanche, wiping out one third of the world's net equity, or $30 trillion, the largest peacetime destruction of wealth. The American financial system, considered the most sophisticated and developed in the world, is now seen as a casino game in which highly paid participants mismanaged risk and highly respected regulators cheered them on.

Looking back, the big question is how the financial brains could have been so blind to the risks in gambling that $1 of equity could support $30 of lending. The public had no idea that the traditional ratio of $12 of debt for every $1 of equity had been recklessly exceeded. But it seemed to be raining money, and the public naturally took advantage of that. Easy money tempted people to buy homes they couldn't afford. Some did so by lying about their assets—if anyone even asked them!—while others grabbed teaser loans with no down payments and low rates that eventually ballooned unbearably. Millions of other homeowners refinanced their mortgages to sustain consumption.

Everybody seemed to think that trees would grow to the sky. It is understandable how ordinary people made that mistake. It is unforgivable that the computer models of the agencies that rated risk were not programmed for a fall in prices. That was the agencies' job, and, impelled by greed, they screwed up big time. So, when people started defaulting on their mortgage payments, homes were foreclosed and home prices began to fall. At that point, the leverage began to work in reverse, generating a credit crisis that was crippling in scope and global in reach.

The Obama administration now has come forth with a series of programs. The administration is offering various incentives to encourage lenders to lower mortgage payments to affordable levels so people can stay in their homes. That's sensible. It is more profitable for lenders than foreclosures—especially since foreclosures tend to accelerate the decline in the value of homes.

But that's a plan that goes only so far. It's available only for mortgages that are not more than 5 percent in excess of the current value of a home. It thus would help perhaps fewer than a million of the 14 million homeowners who are now "under water." To protect the rest, the program will have to find a way to lower the principal owed by homeowners who have larger negative equity, i.e., whose home values have fallen below what they owe on their mortgage. The vast majority of these owners still are likely to go into foreclosure if prices fall more, since they will have no motive to continue making mortgage payments.

The program also would allow millions of homeowners to qualify for refinancing. And, if nothing else works, the administration wants Congress to give bankruptcy judges the power to change the terms of mortgages and reduce monthly payments.

The banking bust that continues to cripple the economy and devastate the stock market is a direct result of the collateral damage of mortgage foreclosures. The decline in the value of mortgage-backed securities, catastrophic for the overleveraged system, has been aggravated by hundreds of billions of dollars of other illiquid and complex assets. The result has been the deterioration in banks' balance sheets that has led them to make a drastic reduction in lending, a deleveraging that, in turn, has produced a sharp decline in economic activity.

The largest component of the credit bust came from the disappearance of the "securitization market"—the packaging and selling of bundles of debt from mortgages, credit cards, auto loans, etc., that made up more than $2.5 trillion, or about 50 percent, of total financing in 2007. Today, that number has gone down to virtually zero: The credit rating system that made these bonds salable to investors has proved to be so unreliable that the market is moribund. Even if the banks were all solvent, they couldn't make up this drastic shortfall of credit. Securitization enabled the banks to roll over loans into securities, which they sold. The banks used the money raised to relend for a second and third time.

Three decades ago, banks supplied $3 of every $4 of credit worldwide, according to the New York Times. Because of securitization, that dropped to about $1 of every $3. So, until investors are willing to buy these bundled loans in the form of securities, credit will remain tight even if the banks resume lending.

This credit squeeze has spread to the shadow banking system, reflected in sharply increased redemptions from hedge funds, and it has begun to feed on itself, forcing hedge funds to sell financial assets into a declining market, which accentuates the financial collapse.

Credit is critical for the American economy, and credit deleveraging is collapsing the money multiplier, which is the financial system's ability to generate liquidity several times the value of its reserves, deposits, or assets. What is more, further deleveraging is inevitable, since current debt loads are not sustainable either by incomes, which are declining, or by asset values, which also are falling. The net effect is a credit freeze where today almost no one, almost anywhere, can get the loans that would have once been assured. This enormous meltdown of credit has moved from a financial crisis to having an impact on the Main Street economy in ways that will unfold throughout this year.

Bubbles have burst in housing, in credit, and, most of all, in confidence.

Both the financial world and the consuming public are holding back until they can see that Washington's programs will work. Banks have lost confidence and are hoarding capital out of fear. Consumers are undergoing a major retrenchment in their buying patterns and also hoarding cash in an effort to build back the trillions of dollars in collective wealth lost in homes and financial assets.

The result is that virtually all components of aggregate demand in the United States are in serious decline, a demand destruction that makes fiscal stimulus essential. That stimulus must be dramatic and large enough to change public attitudes and do more than keep the contraction from continuing at a lower rate.

The public believes we have already spent too much money on bailing out the financial system, especially bailing out the people they blame for getting us into this mess. The Republicans are playing on this understandable resentment. But it is an irresponsible exploitation. Without additional capital, these organizations will remain buried under mountains of bad assets. They will continue to hoard capital out of fear: They do not know how extensive are the problematic loans already on their balance sheets, and, thus, they don't know what might hit them next.

In fact, the odds are that the fiscal stimulus program of the Obama administration, far from being too big, is too small to restart the economy. The administration cannot let that happen. It must, here and now—today, not tomorrow— organize a contingency list of infrastructure programs that will be ready for further funding if it seems we are still in the hole. Officials must do the planning and seek the approvals for projects immediately so they can be ready by the time they might be needed. Particular attention should be paid to the repair and maintenance of highways, bridges, and other transportation infrastructure, for those offer the best chance for an immediate start-up. If the first stimulus programs prove to be inadequate, public confidence in the future of the economy will fall dramatically, and so will confidence in the Obama administration's capacity to repair America's financial systems.

America is going to have to come to terms with the new age of government activism. Speed is of the essence. The longer the downward spiral, the more difficult it will be to get us out of it.

• Read more by Mortimer Zuckerman.
• Read more about economic stimulus.