Thank you, Mr. Chairman. I am pleased to testify today about the
Treasurys Troubled Asset Relief Program and about other steps that I think are
needed to deal with the current economic situation.
The Problem
I am very worried about the U.S. economy. The financial crisis and the economic downturn
are mutually reinforcing. Without further action by the Congress, the current
recession is likely to be longer and more damaging than any that we have seen
since the 1930s.
The fundamental cause of our current problems was
the underpricing of risk and the resulting excessive leverage of both
individuals and institutions.
But the primary condition that now threatens the
economy is the expectation that house prices will
continue to decline, leading to more defaults and foreclosures. And those foreclosures will put more houses
on the market, driving house prices down further.
This potential downward spiral reflects the fact
that in the United States unlike every other country in the world home
mortgages are no recourse loans. If someone stops paying his mortgage, the
creditor can take the home but cannot take other assets or look to the
individuals income to make up any unpaid balance. This no recourse feature gives individuals
whose mortgages exceed the value of their homes an incentive to default and to
rent until house prices stop falling.
Because the number of defaults is now rising rapidly
and is expected to go on increasing, financial institutions cannot value
mortgage-backed securities with any confidence.
Thats what stops interbank lending and lending by financial
institutions that cannot judge the value of their own capital.
The TARP
The actions of the Federal Reserve and the FDIC have
done a lot to prevent a run-off of funds from the banks and from the money
market mutual funds and to maintain the commercial paper market. In contrast, I believe that the TARP itself
has not done anything to resolve the basic problems of the financial
sector.
The Treasurys original plan to buy impaired loans
as a way of cleaning the banks balance sheets simply could not work. Even $700 billion is not enough to deal with
the more than $2 trillion of negative equity mortgages. The plan to buy impaired assets by a reverse
auction also could not work because of the enormous diversity of these
securities. And even if the Treasury had
succeeded in removing all of the toxic assets from the banks portfolios,, they would have done nothing to stop the flow of new
impaired mortgages and the fear of more such toxic assets in the future. It was
good that the Treasury abandoned this asset purchase plan.
Injecting capital into selected banks is also not a
way to resolve the problem and get lending going again. A bank like Citigroup has a balance sheet of
some $2 trillion. Injecting $25 billion
of government capital does not provide a significant amount of loanable
funds. Nor does it give anyone
confidence that Citi would have enough capital to cover any potential losses on
its mortgage-backed assets. Although it
raises Citis tier one capital, that is not the binding
constraint on lending by Citi or on its ability to attract funds. It was good that the Treasury abandoned this
equity infusion plan as well.
Last week the Treasury announced that it will now
concentrate on propping up credit for student loans, auto loans, and credit
cards. I do not know how it plans to do
this. But doing so will not stop the
lack of confidence caused by the expected continuing meltdown of mortgage-
backed securities that is driven by the process of defaults and foreclosures.
In light of this record, the Treasurys announcement
yesterday that it will not seek any of the remaining $350 billion of the
initial $700 billion TARP funding seems quite appropriate.
What Needs to be Done?
Stopping the financial crisis and getting credit flowing
again requires ending the spiral of mortgage foreclosures and the expectation
of very deep further house price declines.
Doing this requires a new government policy that deals with
homeowners who have positive equity and a different government policy for
homeowners with negative equity. Here is
a possible way of dealing with these two groups.
Consider first the problem of stopping homeowners
with positive equity from falling into
negative equity as house prices decline to the pre-bubble level. Earlier this year I suggested that the
government offer all homeowners the opportunity to substitute a loan with a
very attractive low interest rate, but with full recourse, for 20 percent of
the homeowners existing mortgage. This mortgage replacement loan would establish
a firewall so that house prices would have to fall more than 20 percent before
someone who now has positive equity would decline into negative equity. Since the mortgage replacement loan is
essentially a swap of the homeowners IOU for the government loan, it would
involve no actual government spending and therefore no increase in the budget
deficit. (For more details, see my Wall
Street Journal article of March 7, 2008 How to Stop the Mortgage Crisis.)
The key to preventing further defaults and
foreclosures among the current negative equity
homeowners is to shift those mortgages into loans with full recourse, allowing
the creditor to take other assets or a fraction of wages if the homeowner
defaults. But the offer of a low
interest rate loan is not enough to induce a homeowner with substantial
negative equity to forego the opportunity to default and escape the existing
debt.
Substituting a full recourse loan requires the
inducement of a substantial write down in the outstanding loan balance. Creditors now have an incentive to accept
some write-down in exchange for the much greater security of a full recourse
loan. The government can bridge the gap
between the maximum write down that the creditor would accept and the minimum
write down that the homeowner requires to give up his
current right to walk away from his debt.
(For more details, see my Wall Street Journal article of November 18,
2008 How to Help People whose Home Values are Underwater.)
If these two programs are enacted, the financial
sector would be stable and credit would again begin to flow. But while that is a necessary condition for
getting the overall economy expanding again, it is not sufficient.
To achieve economic recovery the nation also needs a
program of government spending for at least the next two years to offset the
large decline in consumer spending and business investment. To be successful,
it must be big, quick, and targeted at increasing production and employment
I am a fiscal conservative. I generally oppose increased government
spending and increased fiscal deficits.
But I am afraid that that is now the only way to increase overall
national spending and to reverse the countrys economic downturn.
If these two things are done -- stopping the incentive to default
on home mortgages and increasing government spending - I will be much more
optimistic about the ability of the economy to begin expanding before the end
of 2009.
###