Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.
The Chairman of the Federal Reserve spoke truth to Paulson this week. Acknowledging the depth of the housing finance crisis (and, like his predecessor, acknowledging the limitations of Fed rate cuts in terms of solving the problem), he directly countradicted Bush Administration policy and urged bankers to accept the reality that they are better off haircutting the principal of underwater mortgages than triggering foreclosures of those mortgages.
The banks would thus not be forced into steep write-offs immediately but only the more minor haircuts involving the excess of mortgage amount over current house price value, and could also move to secure a first-in-line claim on any subsequent price appreciation to claw back the haircuts at a time of later sale
Bernanke was in effect saying that the moral hazard involved in bailing-out the balance sheets of both improvident mortgagors and mortgagees in this manner is less damaging to the economy as a whole than a period of steeper write-downs in the banking industry, a collapse of mortgage credit altogether, and a resultant severe economic contraction that even lower Fed funds rates will be too late to stop. His is neither a Japanese solution to a real estate meltdown (leave the sorry loans on the books too long) or the doctored accounting solution that propped-up the S&L industry in the US in the 80’s well-past its “use-by”‘ dates. His suggestion involves real pain, but more controlled pain — tiring to the body perhaps like targeted radiation, but not sickening altogether like the chemotherapy of excessive rate cuts that also debase the currency and trigger further commodity inflation (at least until that boom is busted by the realities of recession).
Yes, he is making a policy suggestion that to some degree would takes pressure off the Fed –not to mention the declining US dollar, which could firm if the Government acted to facilitate Bernanke’s barber-shop move. But the Government shows no sign of doing so — especially by authorizing more Federal agency mortgage purchases and guarantees.
It is therefore quite possible that the inter-meeting rate cut device employed in January to stave off a capital markets rout will be back on the table — maybe as early as this Friday or Monday morning. There is just too much panic in the US capital markets since Bernanke called the question on the underwater mortgage mess, further illustrated by this week’s figures on increased foreclosures and home equity value deterioration. One thing the economy cannot stand is a stock market crash on top of a credit crunch.
