WASHINGTON — Of all the provisions in the bill designed to stabilize the financial markets, one of its most potent is not getting enough attention, according to Federal Deposit Insurance Corp. Chairman Sheila Bair.
The provision would allow the Treasury Department to provide credit guarantees and enhancements on whole loans. If it were used, it would allow the government to increase modifications and stabilize home prices at a much smaller cost than buying the loans themselves, Ms. Bair said in an interview Thursday.
"They can have so much bigger bang for their buck," she said. "You don't have an initial cash outlay, you can leave them in the private sector, you can do the servicing in the private sector, and you can condition them on some type of modification protocol, which would get the mortgages restructured faster."
The provision, a single sentence in the 451-page bill, has attracted little attention from analysts and industry representatives. Instead, they have focused on the crux of the bill, which would allow the Treasury to buy and hold up to $700 billion of troubled assets.
The bill would give the Treasury secretary the power to "use loan guarantees and credit enhancements to facilitate loan modifications to prevent avoidable foreclosures."
How that would work remains unclear. In theory, the Treasury could guarantee certain types of loans — option adjustable-rate mortgages, for example — and require lenders that want to use the insurance to engage in loan modifications first. If the reworked loan performed, the government would never be involved, but if the loan later defaulted, the government would take a certain amount of the loss.
Though she is supportive of the $700 billion buyout facility, Ms. Bair said the provision, added at the behest of the FDIC, could provide a critical alternative.
"It will be another tool they have in their toolkit, and it will be cheaper," she said. "You can provide credit support to $100 billion worth of mortgages with no up-front cash outlay. The exposure would be less than buying those mortgages directly."
During her two-year tenure, the FDIC has moved from the background to the forefront of the housing crisis. In the past week alone it has handled the largest failure of all time — the $309 billion-asset Washington Mutual Inc. — with no cost to the government. It also invoked the systemic risk exception for the first time in the agency's history to facilitate a deal to sell most of Wachovia Corp. to Citigroup Inc.
Ms. Bair said regulators had no choice but to use the exception, which was created in 1991 and required the approval of the Federal Reserve Board and the Treasury.
"We all felt that preventive action was needed," she said. "It was a potential failure, driven primarily by market confidence issues."
Ms. Bair has also been working to help pass the bailout bill. After the House unexpectedly defeated the legislation Monday, lawmakers scrambled for provisions to bring more Republicans on board. The most notable addition would increase deposit insurance to $250,000 per depositor per institution.
That provision would reassure nervous depositors that the banking system is stable, Ms. Bair said, and it gets to the heart of the problem: a lack of confidence among consumers, bankers, and businesses.
"Raising the deposit insurance limit to $250,000 is designed to address that problem of public confidence," she said. "Expanding that safety net for a period of time, I think, will help with the Main Street depositor and also provide help for banks."
The coverage hike would take effect immediately and would expire Dec. 31, 2009. The bill explicitly says banks should not face a premium hike as a result. Analysts argue that Congress would have to make the higher limit permanent. Ms. Bair would not take a position, except to say the FDIC should have the power to raise premiums if the increase becomes permanent.
"It's a question for Congress," she said. "It could be destabilizing if they lift it in 2009, but the trade-off would be that banks would have to start paying premiums."
Overall, she said, she hopes the legislation will help ease fears among financial institutions, some of which have become worried about lending to each other.
"There is a confidence issue," Ms. Bair said. "Originally, liquidity issues were tied to capital adequacy. Now I think liquidity issues are tied to just uncertainty. … We are asking Main Street to have confidence in the banking system. Well, I would ask the banks to have confidence in the banking system and lend to each other."
She said a freeze on credit is only making the situation worse.
"We acknowledge that some individual banks have challenges, but overall they still have strong capital, and they've built up their loan loss reserves," she said. "We shouldn't be freezing up and panicking."
Though some have argued the bailout bill does not go to the heart of the issue, Ms. Bair was unequivocal in saying she thought the buyout facility would help the situation.
"The reason for the liquidity issue is you have an asset on the balance sheet where the cash flow suggests one valuation, but if you have to sell it, you will be taking a steep loss because the market is seizing up," she said. "So we will be providing a vehicle for moving those assets off balance sheet for a price other than a rock-bottom distressed price. We are capable of letting the government hold the asset for a while before it's sold which will help ease downward pressure on asset valuations. It absolutely should help."
But she acknowledged some concern that the legislation did not do enough to help struggling borrowers.
Ms. Bair was at the forefront last year in warning that lenders and servicers needed to systematically lock in low, starter rates so that borrowers could continue making their mortgage payments on time. More defaults would lead to increased foreclosures, which would cause further deterioration in the housing market. Few took her advice, and the housing market continued to sink.
If more lenders had modified loans, she said the situation would still be bad, but not as dramatic.
"We were going to have these problems no matter what, but I do think it would be less of an impact," she said.
But Ms. Bair said she did not understand why Congress is not doing more to assist borrowers in the bailout legislation. Lawmakers debated forcing more servicers to engage in systematic modifications, but ultimately did not do so.
"I don't understand it," she said. "The borrowers here that are losing their houses have been this politically powerless group. From the get go, politically, for whatever reason, they were put in a category of they got over their head and were an unsympathetic group to deal with. That is not the case with all of them."