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Beware Simple 'Fixes' to a Complicated Financial Mess

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By Steven Pearlstein
Friday, January 23, 2009

One group is convinced that mortgage foreclosures are at the root of the crisis. Solve that, and the rest will take care of itself.

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Another faction is just as certain that toxic assets on banks' balance sheets are clogging the financial arteries, resulting in a credit crunch that is bringing down the economy. Their solution: have the government set up a "bad bank" to buy up all the toxic assets.

Still another has concluded that it's all hopeless and the only solution is for the government to nationalize the banking system, wipe out shareholders, fire all the executives, sell off all the bad assets at fire-sale prices and start again.

With all this conflicting advice, it's no wonder nobody can figure out what to do.

Most of the silver-bullet solutions are based on an oversimplified analysis or colored by the experiences, ideologies and self-interest of those who propose them. Regulators and other veterans of the savings-and-loan crisis like the bad-bank solution. Bankers favor anything that allows them to get rid of their bad loans. Conservatives like anything that holds out the hope of attracting private capital. Populists tend toward nationalization.

It's a guess -- but probably a pretty good guess -- that in the end we'll wind up doing some version of all of these proposals.

In thinking about all this, a good place to start is not with the banks themselves but with the "shadow" banking system -- those markets in which packages of loans are sold off in pieces to investors. In the United States over the past several decades, this shadow system has come to provide roughly half of the financing for businesses and households, including many of the loans that are initially written by banks. Now this shadow system has effectively shut down because investors lost confidence in their ability to know the risks involved in those loan packages. Until their confidence is restored, the credit crunch will continue.

Of all our problems, this one may be the easiest to solve. Banks, investment banks, rating agencies and regulators -- the key players in the shadow banking system -- have now been sufficiently chastened by their past mistakes and are unlikely to repeat them. So if the new loans are written and packaged to meet newly conservative standards, there are likely to be plenty of investors willing to buy them. That would be particularly true if the packages came with a limited government guarantee against default, much as Fannie Mae and Freddie Mac continue to do with conventional mortgage-backed securities. As it happens, the Federal Deposit Insurance Corp. is already working on a plan to do just that, which could be funded through a modest contribution from the Treasury's $700 billion bailout fund or fees charged to the participating banks.

Reducing mortgage foreclosures is also very doable, at a modest cost and without the political firestorm that would erupt were the government to directly bail out homeowners who took on more debt than they could handle. The key is to induce lenders and mortgage servicers to renegotiate troubled mortgages rather than foreclose on them, which in most instances is in their financial interest anyway. The framework for those restructurings already exists in a program passed last year by Congress. Now the FDIC's chairwoman, Sheila C. Bair, has proposed some reasonable changes that would make the program more attractive to lenders and servicers -- things like paying a $1,000 fee to cover the labor costs involved in modifications and providing a partial guarantee against re-default. What I like about the program is that it gives the government a share of any equity in a house if it is eventually sold for more than the value of the restructured mortgage.

Of course none of this addresses the thornier problem of what to do about all those bad loans, and unwanted packages of loans, weighing heavily on bank balance sheets. The list of troubled loans grows by the day and now takes in not only subprime mortgages but also commercial real estate loans, car loans, student loans and corporate takeover loans. At this point, even the Treasury can't borrow enough money to buy them all up.

Nor should it. The evidence right now is not that these assets are worthless, as many commentators have suggested, but rather just the opposite -- that due to the absence of willing buyers, the "market" prices have been irrationally discounted from their long-term economic value. So the better approach would be to find ways for the banks to raise additional capital and hold on to the assets until the market recovers or the loans come due.

One approach is to have the Federal Reserve buy up some of these toxic assets or take them as collateral for fresh loans to the banks. The Fed already has such a "facility" to deal with short-term commercial IOUs and stabilize that market and is about to launch others dealing with commercial and residential real estate loans and other categories of assets. The Treasury provides a modest amount of borrowed money as the equity, or risk capital, for these facilities, which the Fed leverages several times over with freshly printed dollars. By increasing the number or size of these facilities, the government could inject considerable additional capital into the banking system at relatively little immediate cost.

At the same time, rather than using taxpayer dollars directly to recapitalize banks, the Treasury could help banks attract private capital by offering some sort of guarantee of any newly issued preferred stock, much as it has already done for newly issued debt. As payment for its guarantee, the government could demand warrants for up to 49 percent of a bank's common stock, which could be exercised in the future if and when the stock price recovers. Such a guarantee program would also avoid the market-roiling specter of nationalization, force shareholders to give up a sizable share of a company, and offer taxpayers a reasonable return on their investment and risk-taking.

There is a way out of this mess, if only we have faith in the people chosen to manage the process and the patience to see it through. It will almost surely require the commitment of additional funds beyond the original $700 billion, and it will involve several more rounds of trial and error. But most of all, it will require us to resist the fetching idea that there is a simple, quick and relatively painless way to put a complex financial system back together again.

Steven Pearlstein moderates a new Web site, On Leadership, at http://washingtonpost.com/leadership. He can be reached at pearlsteins@washpost.com.


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