Dec 25, 2007
US govt, Congress and Fed scrambling to contain sub-prime crisis
WASHINGTON - AFTER a slow and stumbling start, officials in Washington are scrambling to try to prevent the unfolding mortgage crisis from pushing the United States into recession during an election year.
There is a strong feeling, though, that the government will need to do more to avert a financial disaster.
One former Treasury secretary, Professor Lawrence Summers, who served under former president Bill Clinton, advocates temporary tax cuts and emergency spending in the order of US$50 billion to US$75 billion (S$73 billion to S$109 billion).
Such action could help the US from slipping into what could become the worst downturn since the steep 1981-82 recession. Mr Martin Feldstein, who was former president Ronald Reagan's top economic adviser, and former Federal Reserve chairman Alan Greenspan have called for deeper government intervention to deal with the threat.
Before it is all over, the government may have to resort to measures last used in the savings and loan (S&L) crisis of the 1990s. Back then, it was a new agency to take over failing thrift institutions sunk by bad loans. Today, it could mean a government agency to buy up billions of dollars of mortgage- backed securities that investors are shunning.
The Bush administration thus far has opted for less dramatic measures. In fact, the administration came reluctantly to the biggest step taken to date - the 'teaser freezer' announced two weeks ago.
A deal with the mortgage industry will freeze the low introductory 'teaser' rates for five years on some subprime mortgages - loans to people with spotty credit histories. The rates were to climb much higher, making the mortgages unaffordable for many people and putting their homes at risk of foreclosure.
The hope is that this agreement will buy time for the housing market to rebound. That would make it easier for these home owners to refinance to more affordable fixed-rate loans.
But estimates are that only about 250,000 people will end up getting a rate freeze - a fraction of the 3.5 million home loans that could go into default over the next 21/2 years.
The administration is also working with Congress to increase the US$417,000 cap on the size of loans that the big mortgage companies Fannie Mae and Freddie Mac can handle. This step could help in high-cost housing areas such as California.
These efforts may help at the margins. They do not, however, address one of the biggest threats to the economy: a spreading credit crisis triggered by the soaring defaults on sub-prime mortgages.
Some of the biggest names in finance have suffered multibillion-dollar losses as a result, and critical segments of the credit markets have frozen up. Banks and investors fear making further loans or buying securities backed by debt because they do not know how many more loans might go into default.
The Fed has cut interest rates by a full percentage point since the crisis erupted. But only the September cut - a bigger-than-expected half a percentage point - elicited cheers on Wall Street. The two quarter-point moves brought about market declines as investors worried that the Fed did not recognise the severity of the problem.
The trouble is that the credit crisis is occurring at the same time that a run-up in energy prices is increasing inflationary pressures. And that is the dilemma.
If the Fed cuts interest rates to keep the economy out of a recession, it could sow the seeds for higher inflation and perhaps give the country the worst of both worlds, bringing back that 1970s bogeyman - stagflation - in which growth is stagnant and inflation is getting worse.
In a novel approach, the Fed is auctioning off money to the banks in an attempt to get them to open up their loan taps. The first two auctions, for a total of US$40 billion two weeks ago, went well. But the amount of cash provided to the banks paled in comparison with the US$500 billion from the European Central Bank.
Many economists believe the Fed will have to cut its key federal funds rate - the interest that banks charge each other which, in turn, has an impact on consumer rates - at least three more times and strengthen the wording of its statements.
In that way, the markets would know the Fed will do whatever is needed to fight economic weakness in spite of its lingering worries about inflation.
'The difference between a soft economy and a recession is confidence. If the Fed appears reticent to do what is needed, like they did at their last meeting, that does not help confidence,' says Mr Mark Zandi, chief economist at Moody's Economy.com.
As for the administration and Congress, a tax cut possibly in the form of a rebate probably will be debated in the coming year.
President George W. Bush told reporters at the White House last Thursday that 'we're constantly analysing options available to us'. He insisted that the economy's underlying fundamentals remained strong.
Prof Summers, however, in a speech last week, urged bolder action.
'For the last year, the economic consensus, and the policy actions that have flowed from it, have been consistently behind the curve,' he said.
Gaining some currency is the idea of a government agency modelled after the Resolution Trust Corp of the S&L days that would buy up mortgage-backed securities as a way of dealing with bad loans. About US$100 billion in such loans have surfaced and an additional US$200 billion are likely, according to market estimates.
If the government spent US$150 billion to US$200 billion to purchase mortgage-backed securities, the thinking goes, it would prevent a fire sale that would drive prices of these securities even lower.
When the housing market stabilises, the price of the government-held securities would begin to rise, allowing the government to sell them back to investors.
Whatever approach the government decides to take, economists said it will take time for the current problems to resolve themselves.
They expect this housing downturn, which followed a five-year boom, to last through most of next year even under a best-case scenario in which the country avoids a full-blown recession.
'We have the fundamental problem that we built too many houses and we charged too high a price for them,' says Mr David Wyss, chief economist at Standard & Poor's in New York.
'We have to stop building houses for a while and the prices have to come down. We are trying to make sure that process doesn't derail the rest of the economy.'
ASSOCIATED PRESS
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