American Banker  |  Friday, November 30, 2007

By Rob Blackwell

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Former Treasury Secretary Lawrence H. Summers offered a downbeat assessment of the housing crisis and sharply criticized the government’s efforts to help borrowers avoid foreclosure.

"It defies belief that we cannot organize a way of working to support much more rapid" mortgage modifications "than we have done so far," Mr. Summers said Thursday night in the keynote address of American Banker’s Banker of the Year Awards ceremony. The line gathered enthusiastic applause.

The Bush administration, after initially downplaying the problem, has focused intensely on it in recent days, and sources said Friday that President Bush himself will unveil a series of plans Tuesday to address the threat of massive foreclosures, including an agreement with industry leaders to freeze the rates charged on certain subprime loans.

The exact terms of the deal were still being hammered out Friday. Industry representatives have agreed to modify subprime hybrid adjustable-rate mortgages for struggling borrowers who cannot afford interest rate resets, including extending the starter rates of such loans for some period of time. The representatives said privately Friday that they have not yet committed to a specific time frame, though several observers expect the extension to last for five years.

The initial terms of the deal were hashed out at a meeting Treasury Secretary Henry Paulson held last week with federal regulators and large banking companies. Industry representatives have indicated they ultimately would agree to a plan, though they argue it may be difficult, if not impossible, to implement.

In his speech, Mr. Summers sketched a gloomy economic forecast, noting foreclosures pose a growing threat to growth. (The full transcript is available here.)

Lifetime Achivement award winner L. William Seidman spoke after Mr. Summers and provided a counterpoint.

"We have a tendency to overestimate the losses and underestimate the resiliency of the system," said Mr. Seidman, who guided the government through the S&L crisis of the late 1980s.

Mr. Summers focused on the fallout from foreclosures.

"There are large value losses every time that there is a foreclosure," he said. "Every foreclosure is a source of large, negative … externalities: costs imposed on those who are not party to the transaction; costs imposed on neighbors whose streets become less safe and whose homes become less valuable; costs imposed on cities whose tax base shrinks."

The loan-by-loan approach preferred by the industry, and originally touted by Mr. Paulson, would not work, Mr. Summers said. "I know of no cases where something was done on a completely case-by-case basis and it was done quickly in large scale in any sphere."

He also criticized the Treasury-organized creation of the master liquidity enhancement conduit two months ago. The "superfund" was created by three banking companies to act as a backstop for the asset-backed commercial paper market.

Though it might be an effective solution, Mr. Summers said there is too little information to make an informed assessment.

"It may well be the right thing to do in terms of maintaining capital and maintaining the flow of funds. I just don’t know," he said. "But I know that it has traditionally been U.S. policy, where government is closely engaged with financial institutions, to insist on a high degree of transparency and explanation of what the policy is and why that policy is being pursued. And I don’t think at this late date, a couple of months after the policy’s announcement, we don’t yet have that degree of clarity."

Financial innovations have lost some of their allure, Mr. Summers said.

"The view that if everything’s dispersed and computerized, it’s kind of irrelevant whether anybody knows anybody they’re lending money to, and it’s kind of irrelevant what the names of the institutions are, because it all can just be combined and rated and graded and securitized, and all will be well," he said. "It’s going to take quite a while for those kinds of views to become as fashionable as they were six months ago."

Ultimately, the beneficiaries will be bankers, he said.

"If one thing is clear, anyone who thought that banks were dinosaur financial institutions … it appears to be a much less plausible argument today," Mr. Summers said. "There aren’t going to be as many actors who are prepared to do things outside the banking system as there were before. That makes the kind of ingenuity, creativity, competitive spirit that has long been characteristic of the American banking system something that will be even more important in the years ahead than it has been for the past year."

Overall, Mr. Summers warned that policymakers must be careful in how they react to the crisis.

"All the things that are right to do to prevent it are exactly wrong to solve it," he said. "To prevent it, you want tighter money. You want higher lending standards. You want higher degrees of capital and hoarding of capital, so that you don’t create a credit bubble. When your problem is a lack of confidence, you want all of the opposite things. You want more lending. You want more liquidity. You want more confidence."

He said that he was not sure what the correct response would be. However, it must be based on transparency and putting problems "behind us as rapidly as possible," instead of simply "trying to rearrange" assets.

"I am not sure that we have those policies in place at this important juncture," he said. "We can do better, I believe, than we are doing in shortening the period of difficulty and responding aggressively."

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