As the federal government steps to the center of the financial crisis, devising plans to take ownership of hundreds of billions of dollars’ worth of bad mortgages, a pair of simple questions rise to the fore: Will this intervention finally be enough to restore order? And what will this grand rescue cost taxpayers?
The Treasury Department, as overseer of the financial system, has in recent weeks unleashed a vast array of initiatives in a bid to stave off catastrophe. It took over the country’s largest mortgage finance companies and put untold billions of taxpayer dollars on the line to prop up other lenders.
Now, although the details are still being worked out, the government is dispensing with rescuing one company at a time, and instead is taking on a vast pile of bad debt in one gulp.
If it all comes to pass — if Uncle Sam becomes the repository for the radioactive leftovers of bad real estate bets — will the crisis lift? Will the fear that has kept banks clinging to their dollars, starving the economy of capital, give way to free-flowing credit?
Most broadly, what are the long-term costs of the government’s stepping in to restore order after so many wealthy financiers became so much wealthier through what now seem like reckless bets on housing — bets now covered with public dollars?
Some question the prudence of adding to the nation’s overall debt at a time when the Treasury relies on the largess of foreigners to cover the bills. Even so, there is wide agreement that a broad intervention like the one Treasury is proposing is necessary.
“It goes a long way; it ameliorates it very substantially,” said Alan S. Blinder, an economist at Princeton and a former vice chairman of the board of governors at the Federal Reserve, who has said for months that the government must step in forcefully to buy mortgage-linked investments.
“We’re deep into Alice in Wonderland’s rabbit hole,” Mr. Blinder said.
But significant skepticism confronts the plan. Under a proposal circulating Saturday, the Treasury could spend as much as $700 billion to buy mortgage-linked investments, then sell what it can as it works out the messy details of the loans. But no one really knows what this cosmically complex web of finance will be worth, making the final price tag for the taxpayer unknowable. One may just as well try to predict the weather three years from Tuesday.
Also, what message does that send to the next investment bank caught up in the next speculative bubble and contemplating the risks of jumping in while wondering who is ultimately on the hook if things go awry?
Many economists say such questions are beside the point. The nation is gripped by the worst financial crisis since the Great Depression. Before Thursday night, when the Treasury secretary, the Federal Reserve chairman and leaders on Capitol Hill proclaimed their intentions to take over bad debts, the prognosis for the American financial system was sliding from grim toward potentially apocalyptic.
“It looked like we might be falling into the abyss,” Mr. Blinder said.
As the details of the government’s plans are hashed out, no hallelujah chorus is wafting across Washington, down Wall Street or through the glistening condominiums of the nation. Too many households are having trouble paying their mortgages. Too many people are out of work. Too many banks are bloodied.
Still, the prospect that the government is preparing to wade in deep — perhaps sparing families from foreclosure and banks from insolvency — has muted talk of the most dire possibilities: a severe shortage of credit that would crimp the availability of finance for many years, effectively halting economic growth.
“The risk of ending up like Japan, with 10 years of stagnation, is now much lessened,” said Nouriel Roubini, an economist at the Stern School of Business at New York University. “The recession train has left the station, but it’s going to be 18 months instead of five years.”
If the plan works, it will attack the central cause of American economic distress: the continued plunge in housing prices. If banks resumed lending more liberally, mortgages would become more readily available. That would give more people the wherewithal to buy homes, lifting housing prices or at least preventing them from falling further. This would prevent more mortgage-linked investments from going bad, further easing the strain on banks. As a result, the current downward spiral would end and start heading up.
“It’s easy to forget amid all the fancy stuff — credit derivatives, swaps — that the root cause of all this is declining house prices,” Mr. Blinder said. “If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it.”
For many Americans, the events that have transfixed and horrified Wall Street in recent days — the disintegration of supposedly impregnable institutions, government bailouts with 11-figure price tags — have been less stunning than inscrutable. The headlines proclaim that the taxpayer now owns the mortgage finance giants Fannie Mae and Freddie Mac, along with the liabilities of a mysterious colossus called the American Insurance Group, which, as it happens, insures against corporate defaults. Much like the human appendix, these were organs whose existence was only dimly evident to many until the pain began.
Yet these institutions are deeply intertwined with the American economy. When the financial system is in danger, it stops investing and lending, depriving people of financing for homes, cars and education. Businesses cannot borrow to start up and expand.
“Wall Street isn’t this island to itself,” said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute. “Even people with good credit histories are having a very hard time getting loans at terms that make sense. If that gets worse, we’re going to be stuck in the doldrums for a very long time, because that directly blocks healthy economic activity.”
The financial crisis gripping the United States is the direct outgrowth of the speculative orgy in real estate that began early this decade. Once home values began falling two years ago, the financial institutions that had poured capital into real estate confronted a very big problem.
Over the last year, one financial giant after another has written off billions of dollars worth of mortgage-linked investments. Some have succumbed to the storm. In March, the investment bank Bear Stearns nearly collapsed before JPMorgan Chase bought it at a fire-sale price. This month, the government effectively nationalized Fannie Mae and Freddie Mac — government-backed mortgage companies that together guarantee $5 trillion in American mortgages.
Last week, Merrill Lynch — a name synonymous with Wall Street — found itself forced to pawn itself off to Bank of America. Lehman Brothers, an investment banking giant, collapsed into bankruptcy. Worries now hover over other banks.
“It may not be over,” said Mr. Blinder, the former Fed vice chairman.
Some say the tightening of credit is an unavoidable corrective. For a quarter-century, the American economy has gorged itself on borrowed money, from the speculative investments that created the dot-com boom to the exuberant borrowing that made houses in Las Vegas trade like technology stocks.
“Credit was too easy for too long, and now it’s a little tighter,” said Mark Vitner, a senior economist at Wachovia in Charlotte, N.C. “It’s a necessary though painful correction.”
Others say that in the last few weeks, the profligate era of easy money had swung to the opposite extreme: a widespread reluctance to lend.
“The danger is swinging from far too risk-friendly to far too risk-averse,” Mr. Bernstein said.
The economy has shed roughly 600,000 jobs since the beginning of the year. If healthy companies cannot get their hands on financing, they will not be able to expand and hire.
“What we’re looking at now is simply an amplified version of what we’ve been in since last August,” Mr. Bernstein added. “You’re witnessing a sudden death instead of a slow bleed.”
The impact of the pullback among banks was evident in the interest rates banks pay other banks to borrow money short-term. Traditionally, banks charge one another a little more than 0.2 percentage point over the rate on the safest investment, United States Treasury bills. But on Friday that spread was more than two percentage points, meaning a bank must pay an enormous premium to persuade another to part with its money.
And still no one knows the extent of the carnage. The financial system has acknowledged roughly $400 billion in losses so far, Mr. Roubini estimates, yet as much as another $1.1 trillion may be lying in wait.
As the government steps in to take over bad debts, it is aiming to clear away the detritus and lift the uncertainty, emboldening banks to lend anew. Whether it will work in the long term is a question that awaits reaction from investors. But even the most skeptical economists say this is the path the government must take for confidence to crystallize that a genuine fix is under way.
“It’s not enough,” Mr. Roubini said. “But it’s the first time they have done something that makes a difference.”
