Housing slump causes U.S. to weigh another big bailout

By the time the Great Depression was over, a government-created corporation had become the banker for 1 in 5 American homeowners.

After the savings-and-loan industry faced a catastrophic meltdown in the '80s, the US government spent some $124 billion to clean up the mess.

Get ready for the next chapter in government-orchestrated financial rescues for homeowners and lenders.

As policymakers battle an economic slowdown, some financial experts say that rescue efforts could rise to a scale comparable to the savings-and-loan affair.

That doesn't mean that big banks stand today on the brink of failure. But the government is already working overtime in a bid to prevent the current credit turmoil from deepening:

•Federal agencies and private-sector players are considering a range of new policies, including some that would result in the government buying troubled mortgages and refinancing them. This would come atop other foreclosure-prevention programs recently crafted by the Bush administration. [Editor's note: The original version misidentified the origin of the foreclosure-preventing ideas.]

•Government-created enterprises are single-handedly propping up the nation's sagging mortgage market. Yet they are poised to post quarterly losses this week, which some analysts say could portend a taxpayer bailout down the road.

•The Federal Reserve, in a bid to help banks navigate short-term funding problems, has been lending more freely than usual to lenders in need of cash.

"We're getting a lot of bailout pressures from different directions," says Joseph Mason, a finance expert at Drexel University in Philadelphia. It's unclear how big a bailout will become, but the likelihood of expanding rescue efforts is growing, he says. And it will pay to heed lessons of the past.

"The choice is very similar to disciplining a teenager," he says. Infusions of money may serve an important purpose for the economy, but their effectiveness depends on setting limits as well as providing relief.

In fact, some experts say bailouts are a cause of financial crises, not the solution. In the current housing-market slump, for example, an awareness of past rescues may have lulled lenders into a reckless surge in high-risk loans.

Moreover, critics say that government-sponsored enterprises have gotten too big. In the wake of other hard landings for housing, these entities were designed to foster a stable mortgage market.

But they are so big that if a taxpayer bailout is ever needed, it could be very costly. And their gargantuan size – buoyed by the implicit backing of the US government – has made it harder for private-sector rivals to compete.

Despite the criticism, the government's role in the mortgage market is deeply entrenched – in good times as well as bad. And it is seen by many as a source of strength.

For one thing, Fannie Mae and its sibling enterprise, Freddie Mac, are chartered to make sure that mortgages can be available even if other channels of credit are drying up.

"We will take our lumps," Daniel Mudd, Fannie Mae's chief executive, told a congressional hearing earlier this month. "Yes, these are tough times, but that is when you want a Fannie Mae."

Indeed, many of the current ideas for assisting the housing market in recent months have involved expanding the role of these so-called GSEs (government-sponsored enterprises). The recently passed economic-stimulus package includes a provision opening the door for Fannie Mae to guarantee higher-cost loans in the $700,000 range, up from a ceiling of $417,000.

The help from Fannie and Freddie comes during a period of great uncertainty for the investors who, during the recent real estate boom, were eager buyers of home mortgages. Ever since much of that market dried up last year as worries mounted about the soundness of those home loans, the GSEs – almost alone – kept buying and successfully reselling mortgages, providing much-needed liquidity to lenders.

Yet this reliance on the GSEs comes as home prices – and hence the value of home loans – remain in a state of weakness. The GSEs could see quarterly losses, expected in reports this week, continue to rise for some time if the housing market fails to recover.

"People think of them as rocks of Gibraltar," says Dean Baker, an economist at the liberal Center for Economic and Policy Research in Washington. "It's very possible they're going to end up in serious trouble. [But] I'm sure the government will step in and give them the money they need to keep going."

Beyond the GSEs, policymakers are considering other ways to help the housing market – efforts that may also carry costs or risks.

The Bush administration has moved to expand the number of home loans insured by the Federal Housing Administration. Public officials and private-sector lenders have announced partnerships -- Hope Now and Project Lifeline -- designed to prevent foreclosures and refinance at-risk loans.

In addition, lawmakers and administration officials are discussing with private-sector parties whether additional policies might be useful. One idea: Create a new agency that would modify loans in bulk -- arguably faster than private lenders can now do for themselves. The agency would acquire the loans at a discount, reflecting the current property value.

"The committees are looking at such proposals," says Lawrence Di Rita, a spokesman for Bank of America. "We have offered some ideas" on how such a plan might work, although he says the bank is not actively promoting the move.

"Everybody shares the objective that foreclosures are not in anybody's interest," Mr. Di Rita adds.
The ideas of a new agency echoes the Depression-era Home Owners' Loan Corp., which made about a million refinance loans as banks and borrowers struggled through the 1930s.

Support for this step may hinge on the state of the economy in the months ahead. Many economists say the nation may now be on the verge of recession, and gloomy news would increase the chance of greater intervention by politicians. Sen. Christopher Dodd (D) of Connecticut is one of proponent of the mass buyout idea. [Editor's note: The original version misstated Bank of America’s role in originating the concept of a new agency.]

Such a move might help stabilize the housing market by reducing the pace of foreclosures – which put downward pressure on house prices. Proponents hope that such a move might help nudge buyers back into the housing market, since many are now on the sidelines.

It may mean a financial risk for the government, if homes keep falling in value. The hoped-for benefit: A boost to the economy by keeping many borrowers and lenders alike out of trouble.

In the end, economists say the rationale for bailouts is not to help specific banks or homeowners, but to help maintain the economy's normal flow of credit.

In this light, Mr. Mason offers several lessons from the past on how to do bailouts right. If banks are insolvent – facing a long-term cash-flow problem – short-term lending (such as the Federal Reserve's recent efforts) only prolongs the problem.

What's needed instead, he says, is for policymakers to make tough choices about whether bailouts are warranted. Some institutions should be allowed to fail, he says, while any bailouts should match infusions of new capital with tight oversight. It's in the public interest to see new loans made, but ones that are "safe and sound," not high-risk, he adds.

From the Depression on, he says, that approach has been successful, while "half measures ... are only a waste of money."