If only Wall Street and Treasury Secretary Henry Paulson had listened to Sheila Bair, we may have averted this financial meltdown.
As the chairwoman of the Federal Deposit Insurance Corp., Ms. Bair is perhaps the most prescient regulator in U.S. history. Last October, when she foresaw the immense scale of the foreclosure crisis, she proposed a straightforward but revolutionary idea: Mortgage lenders should permanently freeze all adjustable-rate mortgages at their starter rate.
The major cause of the economic meltdown is not seriously disputed. Lenders and mortgage brokers sold millions of subprime adjustable-rate mortgages to borrowers who defaulted when the interest rate spiked. The resulting and continuing wave of foreclosures caused the disintegration of numerous Wall Street firms and pushed our economy and that of other countries to the brink of collapse.
Ms. Bair's solution of permanently freezing rates would have addressed two critical problems. First, it would have kept people in their homes and mitigated the number of foreclosures. Every foreclosure is a lose/lose proposition, where the family gets evicted and the lender loses about half the loan's value. Moreover, by reducing the number of foreclosed properties, the supply of housing would have decreased, and home prices would have stabilized more quickly.
Second, Wall Street firms would have been able to determine the value of securities linked to mortgages. With the rising tide of foreclosures, these securities became extremely difficult to value and toxic, because no one had any idea how much they were actually worth. By freezing interest rates, lenders and investors would have taken some loss, but at least the loans would still be performing and could be valued.
If a family were able to make the first three years of payments at the starter interest rate, chances are they could have made the same payments for the next 20 years.
Unfortunately, Ms. Bair's proposal never gained traction. I, along with other members of the California State Assembly, held a press conference in December urging support for Ms. Bair's proposal, but no one in the Bush administration listened to us. Lenders and loan servicers argued that there would be a backlash from investors. Conservative bloggers said Ms. Bair was clueless.
Mr. Paulson then concocted an entirely voluntary plan, dubbed "Hope Now," that did virtually nothing to stem the impending crisis. Unveiled with great fanfare in December, this plan provided a temporary interest rate adjustment but no permanent rate freeze. It applied to a small, essentially meaningless slice of loans, and it provided no penalty to lenders who failed to participate. Hope Now failed.
Mr. Paulson, who repeatedly misjudged the scale of this crisis, then doubled down on his Hope Now idea and came up with "Project Lifeline" in February, which was going to do "targeted" outreach to some homeowners. This voluntary program, which again relied on the good graces of Wall Street firms, also failed.
We are still waiting for Mr. Paulson to acknowledge his missteps. In the meantime, he now controls $700 billion of taxpayer bailout money. There are still millions of risky, adjustable-rate mortgages that have not yet reset and will default if nothing is done, further driving down the economy. RealtyTrac reported that in August there were 303,879 foreclosure filings in the United States, or about one filing every 10 seconds.
Rather than just buying up toxic mortgage securities and bank shares, Mr. Paulson should use the leverage and money he now has to force a permanent rate freeze on all adjustable-rate mortgages. This is the bold action we need, because it will actually mitigate foreclosures and start stabilizing home prices.
Increasing liquidity is important, but that is not the source of the problem. It is as if a doctor gave aspirin to a patient with pneumonia to bring down the fever. That is helpful, but what the patient really needs is an antibiotic; otherwise, the fever will keep recurring. Until we do something serious about foreclosures and home prices, the liquidity issues will keep recurring.
In contrast with the Bush administration, both presidential campaigns have already figured out that ignoring the foreclosure problem will only make things worse. We cannot begin our economic recovery until we stanch the colossal wave of foreclosures. It is not too late for Mr. Paulson to finally listen to his prescient colleague at the FDIC.
