News Story

There is now an unfortunate perception on Wall Street, Main Street, K Street and beyond that the U.S. financial system now faces a “financial 9/11.” Some accordingly urge a “financial U.S.A. Patriot Act” be passed quickly. Treasury Secretary Paulson, Fed Chairman Bernanke, and others urge that Congress confer barely reviewable discretion on Treasury, to employ up to $700 billion in federal funds for the purchase of illiquid assets seizing up credit markets.

A growing number of objectors balk at the breadth of discretion, and the Iraq-rivaling expenditure, that Paulson’s proposal would place at Treasury’s disposal. Others object the proposal gives Wall Street a pass on improvident practices at Main Street’s expense. Still others observe that the plan will do nothing for Main Streeters whose deceptively marketed home mortgages now face default. Finally, some even charge Treasury’s proposal with “financial socialism.”

Lost in this trading floor hubbub is an obvious solution right under our noses, one that avoids all the worries just cited. That is to restore, at least temporarily, the business of low-end mortgage finance to that agency which first made low-end mortgages possible and then handled the bulk of them for decades: the Federal Housing Administration, or FHA, working in tandem with its originally government-sponsored sibling enterprises (GSEs), Fannie Mae and Freddie Mac. Treasury’s “new” plan for bailout is these institutions’ bailiwick.

FHA and its siblings were breathtakingly innovative when first introduced at the end of the Hoover and start of the Roosevelt Administrations. They were founded, moreover, precisely to address our last economy-wide home-foreclosure crisis – and the Depression it deepened or caused. For decades they discharged this function astonishingly well – before it was given to Wall Street. For they quickly transformed us from a nation in which fewer than 40 percent owned their own homes, to a nation in which 70 percent do. They can do it again. In so doing they’ll save Wall Street and the broader economy too.

Here is how: First distinguish two very different components of the present “crisis.” The core component is a comparative minority of subprime-mortgage-backed securities (MBSs) of questionable worth, widely held by many financial institutions (FIs). These securities are now generally thought “toxic” because many – but not all and not even a majority – of the mortgages backing them are troubled.

The second and peripheral, but now growing component of our crisis is psychological: It is a market made jittery by uncertainty over what portions of FIs’ portfolios take the form of the troubled MBSs. The longer-enduring these jitters, the more apt investors become for brief periods to undervalue affected institutions’ portfolios – even the “good” portions thereof. The more that investors then seek to shed stakes in these institutions, the more rapidly the remaining such stakes lose their short-run values. An all too familiar “downward spiral” – a self-fulfilling prophecy – ensues. The psychological component of the problem ultimately grows larger than the initiating component, even though causally rooted in it.

What is the solution, and what do FHA and its GSE siblings have to do with it? Simple: Immediately reverse the downward spiral by directly addressing the cause at its core – the bad mortgages and the securities they back. Do so through precisely those agencies originally created and still best equipped to deal with these mortgages and securities – FHA and its GSE siblings. That way you not only address the core problem directly and avoid the objections now raised before Treasury: You also cabin the peripheral psychological problem by signaling clearly to all that the real, underlying problem is discrete, containable, and now well contained.

How would the plan work in detail? Several variations are on offer, one of them my own. What’s most important for now is what’s common to all of them, and even to one part of Treasury’s plan: First purchase the “toxic” MBSs at a rate greater than currently undervalued market, but lower than more “fundamental” discounted cashflow value, from key FIs needing to shed them. Second, simultaneously arrange refinancing and financial counseling for those home-buying borrowers who, owing to mispackaged privately hyped mortgages, find themselves post 2006 real estate slump now under water.

All of this, again, is precisely what FHA and its GSE siblings have always been for. Once they stabilize the mortgage market, moreover, the subprime securities they remove from that market will return to their “fundamental” values: FHA, already our sole self-financed federal agency, will then more than recover its costs. We can revisit the ultimate shape Fannie and Freddie should take later. But for now, since we’ve just restored their national status and they remain our main mortgage-securitizers, use them as originally intended and long used before privatization: Use them for Main Street, in a manner that also saves Wall Street.

For a longer version of Professor Hockett's plan, see the working paper at his SSRN site.

Robert C. Hockett teaches international finance, financial institutions, and financial regulation at Cornell Law School. He is currently completing a book titled A Jeffersonian Republic by Hamiltonian Means: Democratized Finance for a Just and Sustainable “Ownership Society.”