Not Just Equity Injection

13 10 2008

Nobel Prize Winning Economist Paul Krugman provided the most succinct and comprehensible explanation as to why we need to inject liquidity into financial markets I have seen thus far in his column today.

What is the nature of the crisis? The details can be insanely complex, but the basics are fairly simple. The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.

What can be done to stem the crisis? Aid to homeowners, though desirable, can’t prevent large losses on bad loans, and in any case will take effect too slowly to help in the current panic. The natural thing to do, then — and the solution adopted in many previous financial crises — is to deal with the problem of inadequate financial capital by having governments provide financial institutions with more capital in return for a share of ownership.

This sort of temporary part-nationalization, which is often referred to as an “equity injection,” is the crisis solution advocated by many economists — and sources told The Times that it was also the solution privately favored by Ben Bernanke, the Federal Reserve chairman.

I, of course, am no economist, but I do have to quibble with the intimation that aiding homeowners somehow cannot be enacted concurrently with a plan to inject more cash into the credit markets. And even if the Gordon Brown plan successfully contains the global credit crunch, that does not necessarily mean that it might not still be adversely affected albeit to a lesser extent by a persisting foreclosure crisis.

Earlier this year Credit Suisse estimated that 6.5 million mortgages could fail by 2012. Now some of that could be abated by simply freeing up credit, but that’s not a real panacea. A few weeks ago Joseph Stiglitz recommended a set of principles that would help stem the foreclosure crisis that has gotten surprising little attention.

First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit. The government effectively pays 50% of the mortgage interest and real estate taxes for upper-income Americans, yet does nothing for the poor. Second, bankruptcy reform is needed to allow homeowners to write down the value of their homes and stay in their houses. Third, government could assume part of a mortgage, taking advantage of its lower borrowing costs.

I  especially agree with the need for bankruptcy reform.  If Congress gets together again after the election to pass a stimulus bill, it should do contain provisions allowing bankruptcy court judges the option of adjusting the interest rates and even the principal on how much homeowners owe their debtors. It could save homes and allow people to put their financial lives back together again.

If we are going to throw cash at financial markets, we at least need to provide aid to homeowners.

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