Taxpayers angered by Washington's rush to rescue the financial industry can be thankful for the looming elections in November, which made lawmakers acutely sensitive to the costs and beneficiaries of the bailout. The root of the credit crisis, though, is much closer to Main Street than Wall Street: It's the worsening problems in home mortgages.
Foreclosure filings jumped again in August, as did the number of homes repossessed. The metastasizing defaults have dried up demand for the complex mortgage-related securities held by many financial firms. The bailout plan developed over the weekend could ease the crisis by putting a price tag on those assets, revealing which firms are healthy and thus restoring the trust that's crucial to the credit markets. Yet it also would saddle the Treasury Department (i.e., taxpayers) with assets that will lose value if foreclosures continue to mount.
Some advocacy groups and lawmakers want the government to help borrowers and taxpayers by calling a timeout on foreclosures. That's a bandage, not a fix. Eventually, home values will fall to a level that's sustainable without government help. As they do, though, Congress can ease the pain for some borrowers trapped in bad mortgages by allowing bankruptcy judges to modify their terms in ways that lenders either can't or won't.
In a slumping market, borrowers, lenders and investors in related securities all lose when homes are repossessed and resold. Lenders have a voluntary program to keep troubled borrowers in homes, but it has been handicapped by legal and financial issues. Bankruptcy judges, by contrast, would have more latitude to write off debt and lower interest rates for borrowers who could afford their homes at their current, reduced values. The change wouldn't spare the many defaulting borrowers who simply took on too much debt. Yet the mere prospect of a judge's intervention could prompt more aggressive efforts by lenders to write down balances and slow the pace of foreclosures.
Mortgage lenders oppose a change in bankruptcy law, arguing that it would sharply increase the cost of home loans even if the relief were limited (as it should be) to existing mortgages. Yet the experience with farm, commercial real estate and vacation home loans -- all of which can be restructured by bankruptcy judges -- suggests that the increase in costs would be much less than the mortgage industry predicts. More important, a reduction in foreclosures would trim the losses throughout the financial system, including the ones taxpayers would face from an epic Wall Street bailout.