The Bush administration swung for the fences Friday with an unprecedented bailout of the financial sector that will cost taxpayers “hundreds of billions of dollars.”
It jolted markets back to life for the day, with the Dow Jones industrial average closing up about 370 points, but questions remained about whether the bold effort would actually work.
The truth is, no one knows. America and its financial markets haven't been down this road before.
A deeply troubled housing market is at the root of the nation's financial problems, and plans announced by Treasury Secretary Henry Paulson address some elements of that.
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But the plan is silent on many other important areas.
The urgency behind Paulson's plan, say experts, comes from fears that what started as a problem in housing finance would spread to other areas of the economy in a way not seen since the 1930s.
“We are in danger of not having the money to finance auto loans,” Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, said Friday as he discussed the deepening crisis on C-Span. “We were in danger of there being enormous damage to the financial system.”
Congressional leaders from both parties agreed to work through the weekend to craft legislation that would authorize the Bush administration's plan to buy up all of the mortgage-backed securities at the root of the problem and get them off the books of banks and other lenders.
Paulson announced the plan Friday, saying he would work with Congress to craft a “mechanism” to take responsibility for the securities, which are made up of mortgage loans that have been packaged together, then sold to outside entities that earn their profits through the mortgage payments made against the individual loans.
No one knows, however, precisely how much money is tied up in those securities. Paulson estimated that the cost of buying them will be in the “hundreds of billions of dollars.” Others said the cost could be more than a half a trillion dollars. For comparison, the total size of U.S. debt is estimated at around $10 trillion.
Certainly, the plan's cost will dwarf the $124 billion taxpayers spent in the 1980s during the savings-and-loan crisis when a government entity, the Resolution Trust Corp., was created to take possession of and then sell off the bad assets of failed thrifts.
Analysts, however, said the risks of doing nothing were growing daily as other economic woes combined with the deep slump in home prices to push the already-high mortgage-default rate even higher.
“Now we're looking at higher unemployment, the economy stalled, and that could by itself lead to another wave of foreclosures that nobody has anticipated yet,” said Rick Sharga, vice president of RealtyTrac, a research company in Irvine, Calif., that provides widely followed statistics on foreclosures nationwide.
How bad is it? RealtyTrac expects about 2.8 million mortgages to be delinquent or in default by the start of 2009. And, said Sharga, there are likely to be 1 million bank-owned properties by the end of this year – independent of the Treasury plan – “which will make it difficult to keep prices from plummeting further.”
There are about $60 billion worth of nontraditional mortgages – mostly so-called alt-A loans given mainly to borrowers with weaker credit – that have contract clauses that early next year could nearly double monthly payments for many homeowners. This trigger kicks in if a home's loan-to-value ratio erodes sharply – something that has already happened in many parts of the nation.
If home prices keep falling, it will trigger yet another round of mortgage delinquencies next year and make a bad situation even worse.
“If we then layer on top of that a recession, or just significant job losses, then it is going to increase delinquencies … then we will see things get worse,” said Jay Brinkmann, chief economist for the Mortgage Bankers Association in Washington.
This will likely be the argument Democrats make over the next week as they push for another economic stimulus plan to help stave off recession. The key to avoiding recession, however, may be the degree to which Paulson can unthaw frozen credit markets.
There were many unanswered questions:
How would a price be set for the securities? There currently is no market for them, which would make their value in the market zero. But the government is likely to pay something on the order of 30 cents to 40cents on the dollar for them.
Which securities would be eligible to be acquired by the government? The securities are held not only by U.S. banks and brokerage houses, but also by foreign banks, hedge funds and even individual investors. Whether they'll all be able to offload their risk to the government wasn't clear.
How long will the process take? Unwinding mortgage-backed securities will be far more complicated than the 1980s savings-and-loan bailout, when a troubled thrift could be taken over by the government and a particular piece of real estate could be sold off to cover the corresponding mortgage.
But mortgages today are “financially engineered” – pooled together and sliced and diced into mortgage bonds that are then sold to investors.
The bonds were made up of mortgage loans of varying risks in an effort to spread the danger of default widely. But it's unknown what each piece of these complicated bonds is actually worth when home prices are declining so sharply.
“They're going to have a much more difficult time differentiating and trying to sort that out,” said former Ohio Rep. Michael Oxley, a former Republican chairman of the House Financial Services Committee, in an interview Friday on CNBC.