Bailout’s strategic target: housing

Times Staff Writer

The government’s $700-billion plan to bail out the banking system may calm panicked financial markets, but its real value may be in buying time to address the root problem: the continuing slide in housing values.

The Treasury Department’s rescue plan is far from a done deal, with Democrats saying Sunday that they would push for more relief measures aimed at homeowners facing foreclosure and for stricter oversight of the program that would allow the government to buy up billions of dollars of securities tied to troubled mortgages.

But there was broad agreement that the government must move quickly, decisively and comprehensively to get the global financial system moving again.

“What’s been lacking is strategic oversight, as opposed to swatting one fly and finding 10 others,” said William R. Gruver, a professor of management at Bucknell University and a former partner at Goldman Sachs & Co., after the broad outlines of the plan were released late last week. “We have to get to the underlying housing issue: If people were still making their mortgage payments, we wouldn’t be here talking about these other problems.”

The rescue plan does nothing in itself to shore up the housing market. Rising defaults and foreclosures on home loans, spurred partially by declines in home values, are the cause of the collapse in price and tradeability of the mortgage-backed securities on the books of banks and investors.


But without government action to aid battered banks, financial experts say, mortgages would remain difficult to get and the housing market’s recovery would be further delayed. The most recent sales figures for Southern California show that median prices were down 34% last month compared with a year earlier. About half the homes sold were foreclosures.

“The nub of the problem is mortgage-backed securities that people have a hard time valuing, and [the rescue plan] doesn’t address that,” said James R. Lothian, a professor of finance at Fordham University and a former executive at Citicorp. “But the basic thing that needs to be done is to provide liquidity to the banking system and markets so we don’t have bank runs going on.”

The need for a federal bailout was underscored after private solutions to the crisis fell by the wayside -- notably last week, when Wall Street banks failed to assemble a rescue plan for insurance giant American International Group Inc. and Lehman Bros. Holdings Inc.

“You need the ultimate sheriff to come into town to cool things down, and that’s a role only the government can play,” said Eugene A. Ludwig, a former U.S. comptroller of the currency.

The bailout plan, laid out in a 2 1/2 -page document delivered to congressional leaders Saturday, would in effect allow the government to act as an investment bank, buying debt from troubled banks and other financial institutions stuck with securities tied to distressed mortgage loans.

Some believe that the securities to be purchased by the government are so undervalued now that they may eventually turn a profit.

UC Berkeley economist Thomas Davidoff said that, if executed properly, the plan could net a profit for the government, though he cautioned that this was a big if.

“The total value of these mortgages has fallen so much that the fall in value [of mortgage-backed securities] may be in excess of what can reasonably happen even in a really bad foreclosure situation,” he said.

Treasury Secretary Henry M. Paulson and others pushed for the plan after months of turmoil stemming from the mortgage meltdown, which included the collapse of mortgage lenders like Countrywide Financial Corp. and investment banks like Lehman Bros. and Bear Stearns Cos. The crisis of confidence accelerated last week after a money market fund “broke the buck” -- allowed its share value to drop below $1 -- because of its exposure to Lehman Bros. That was significant because although these funds are not insured like bank deposits, they have been marketed to the public as rock-solid investments that would always keep their value.

Industry and government leaders feared that the loss of confidence would drive investors to withdraw money from the popular funds in quantities they could not meet.

Still, bringing the money funds under the umbrella of government bank regulation could create its own problems.

“If you extend insurance, you must extend control,” said Lawrence E. Harris, professor of finance at USC’s Marshall School of Business and a former chief economist for the Securities and Exchange Commission. “If they don’t regulate them, there will be huge problems. But I’m not sure they have the resources in place to regulate them.”

The housing market’s path to recovery remains the chief imponderable in the financial crisis. Economists generally agree that a housing recovery is essential to an overall financial recovery, although there is a difference of opinion over how aggressively the government should intervene to prop up home prices.

The rescue plan “is not going to keep a bubble inflated,” said economist Dean Baker, co-director of the Center for Economic and Policy Research in Washington, “There’s nothing you can do to prevent the future meltdown of the housing bubble and nothing you can or should do to keep home prices from falling further.”

The debate over whether and how to intervene in the housing market is likely to prove highly contentious in Washington. Many taxpayers will perceive Paulson’s plan as a bailout of wealthy executives, including some whose lax investment policies contributed to the crisis. Yet a homeowner bailout may be a political minefield itself, as many homeowners current on their mortgages view such assistance as a payoff to irresponsible borrowers.

Democrats are also likely to press for a tightening of financial regulation as the price of bailing out large financial institutions. Some of these regulations may garner bipartisan support. These include closer supervision by the Federal Reserve System of investment banks that have benefited from unprecedented access to Fed lending facilities, on the principle that the Fed deserves to have more jurisdiction over institutions with access to its money.

Others will press for more disclosure of trading positions and the inherent risks of some of the exotic investment instruments cluttering bank ledgers.

The investment industry is likely to resist regulations that set capitalization standards for institutions other than banks or set limits on how much they can borrow. Investment banks have traditionally resisted such standards, which limit their growth.

At the same time, given that unrestrained credit was a strong contributor to the crisis, the industry may not be able to stave off tougher rules.

“In the aftermath of the Great Depression, we got a lot of regulations that didn’t work and created problems years later,” Fordham’s Lothian said. “It’s not like we don’t have myriad regulations already.”

Despite the plan’s huge costs, there appeared to be widespread agreement that a government initiative on a large scale was needed.

“Main Street is as much at risk as Wall Street,” said Ludwig, the former federal regulator. “If we failed to act, the resulting loss of jobs, malaise in growth, damage to the engines of our economy and harm to the American taxpayer would be far more costly.”


Times staff writers Richard Simon, Nicole Gaouette and Peter Y. Hong contributed to this report.