By Michael S Barr and Laura D Tyson

The US economy is caught in a vicious downward spiral of declining home prices, escalating foreclosures, rising losses on mortgage-backed securities, and disappearing liquidity. The liquidity crisis has spread rapidly from the mortgage market to engulf other forms of consumer credit, commercial real estate, and municipal and corporate debt.

Alarmed by the spectre of a prolonged economic slowdown, both the Federal Reserve and the US Congress have acted aggressively to stimulate demand through monetary and fiscal levers. The US Treasury has pressed mortgage holders to restructure mortgages and suspend foreclosures on a voluntary basis. But the continuing turmoil in financial markets confirms that these actions are not enough. Restoring confidence and liquidity in credit markets requires bold action to restructure the overhang of distressed assets and contain the losses in the US housing and mortgage markets.

The scale of the challenge is sobering. Foreclosures in the US are 65 per cent higher than a year earlier. Up to two million foreclosures are anticipated within the next two years. Sharply falling home prices have put a growing number of homeowners underwater, with debt levels that exceed the value of their homes. Goldman Sachs estimates that if home prices fall another 15 per cent, about 15 million homeowners - 30 per cent of all US households with mortgages - will face negative equity in their homes.

Declining property values and escalating foreclosures wipe out family equity, the fuel behind strong consumer demand. Foreclosures drive down the values of surrounding homes. And foreclosures are bad news for investors and financial institutions holding mortgages and mortgage-backed securities.

The inability of the investor community to agree on meaningful voluntary actions to stem foreclosures attests to both the scale of the problem and to the crisis of confidence and lack of transparency impairing capital markets rife with divided ownership and conflicts of interest. The voluntary plan pushed valiantly by FDIC Chair Sheila Bair and the US Treasury has been met with foot dragging by the market.

Rather than a measured market correction warranted by the underlying quality of assets, we are on the verge of a panicked freefall in US home prices and mortgage-related assets. The time for loan-by-loan restructuring of threatened mortgages has passed. The government must create a process for the rapid and transparent re-pricing and restructuring of existing mortgages.

With colleagues at the Center for American Progress, we’ve developed the Saving America’s Family Equity (SAFE) loan plan to achieve these two objectives. SAFE is inspired by the successful Home Owner’s Loan Corporation introduced in 1933 to deal with an unprecedented wave of foreclosures in the Great Depression.

Under the SAFE loan plan, Treasury and the Federal Reserve would run auctions, in which Fannie Mae, Freddie Mac and Federal Housing Administration originators would purchase mortgages from current investors at discounts determined by the auction process. Investors would take a hit, trading a reduction in asset value and yield in exchange for liquidity and certainty. The Federal Housing Administration, Fannie Mae, and Freddie Mac would work with responsible originators to restructure the loans they acquire to stem defaults, foreclosures, and liquidations. Only loans on owner-occupied homes would be eligible for restructuring and speculators would be excluded.

Most of the refinanced loans would take the form of new fixed-rate 30-year mortgages underwritten to 80% of current home value. Backstop credit enhancements would be provided by FHA, Ginnie Mae and Treasury in return for a fee. SAFE loans would be pooled into securities and sold to private investors. Once normal conditions were restored to credit markets, the SAFE plan would automatically cease operation.

But there is nothing normal about conditions in our housing or credit markets today. That’s why we need SAFE to stem the downward spiral of foreclosures and plummeting housing prices that has undermined liquidity and confidence in global capital markets and that threatens a long, painful recession in the US and a global growth slowdown.

If the government fails to take strong action now to facilitate private sector resolution of the crisis, more aggressive government intervention will be required later. By that time, the bill for resolving the US Savings and Loan crisis of the 1980s is likely to look modest by comparison.

Michael S Barr is a professor of law at the University of Michigan Law School. Laura D Tyson is a professor at the Haas School of Business, University of California-Berkeley. Both are senior fellows at the Center for American Progress in Washington DC.

March 3, 2008 1:13pm in Uncategorized | Comment