Laura Rowley Money & Happiness

Fed's 'Consumer Bailout' Encourages More Bad Behavior

Posted on Wednesday, November 26, 2008, 12:00AM

If there's a small silver lining in the nation's financial crisis, it's that households were finally getting a grip on their bloated balance sheets, reducing credit card use, and increasing savings. Consumer spending fell 1 percent in October, the biggest drop in 7 years.

But Treasury Secretary Henry Paulson doesn't want Americans to stop spending, because that will slow the economy. So he's using taxpayer dollars to make it easier for consumers to dig themselves more deeply into debt.

More of What Ails Us

The Treasury announced Tuesday that it will buy $600 billion in mortgages and mortgage securities backed by Fannie Mae and Freddie Mac, and provide $200 billion in non-recourse loans to investors holding investment-grade (BBB or better) securities backed by newly or recently originated consumer loans. That includes credit cards, auto loans, and student loans, as well as small-business loans guaranteed by the Small Business Administration. The $200 billion will come from the Treasury's Troubled Asset Relief Program (TARP).

"Millions of Americans cannot find affordable financing for their basic credit needs. And credit card rates are climbing, making it more expensive for families to finance everyday purchases," Paulson said Tuesday. "This lack of affordable consumer credit undermines consumer spending; as a result, it weakens our economy."

It's an ironic solution to a crisis perpetuated in part by consumers signing on for more debt than they could ever hope to pay off. But it's not a surprising development amid the scattershot rescue strategy that has the government prepared to pledge $7.76 trillion on behalf of American taxpayers — $24,000 for each man, woman, and child, and enough to pay off half the nation's mortgages — according to a Bloomberg analysis.

Taxpayer Stuck with the Tab

Paulson called the $200 billion in the Term Asset-Backed Securities Loan Facility (TALF) "a starting point." In other words, at a time when record numbers of consumers have spent themselves into insolvency, and millions of others face increasing job insecurity, the government is hoping to balloon their borrowing — propping up spending in the short-term but potentially setting the stage for another debacle in the future.

"You have to ask a simple question: Why is this necessary?" says Adam Lerrick, an economist with Carnegie Mellon University and a visiting scholar at the American Enterprise Institute. "Why don't the markets do this themselves? The obvious answer is they don't believe in the Triple-A rating [on the asset-backed securities]. Why should the Treasury have more confidence about the rating agencies than the market? What it's doing is shifting the credit risk of the bonds from investors to the taxpayers."

A Backdoor Bank Bailout

Lawrence J. White, economics professor at New York University's Stern School of Business, says the new strategy is a result of TARP's failure to provide liquidity after the Treasury shifted from purchasing toxic assets to buying equity stakes in financial institutions. "We didn't get a lot of liquidity out of the initial uses of the TARP program because it basically went into the banks' net worth," he says. "They weren't that much more inclined to lend. In some sense, this is a backdoor TARP."

Lerrick argues that the financial system doesn't have a liquidity problem — it has a transparency problem. "There's plenty of liquidity — lenders have more cash than borrowers need," he says. "But we have an information crisis. Let's assume there are 100 major financial institutions in world, and 20 are in bad shape. If you don't know which 20 of those 100 are bad, you don't lend to anyone. The solution is to provide the markets with information so they can identify and go back to lending to the 80 sound borrowers, and quarantine the 20 bad borrowers. That's why massive injections of liquidity have done nothing to unfreeze the credit markets."

Consume No More

But even if a gusher of credit is forthcoming, the era of consumer-driven economic growth is over, argues Robert Manning, professor at the Rochester Institute of Technology and author of "Credit Card Nation: The Consequences of America's Addiction to Credit." "It's astounding how much consumer debt has increased since 2001, and government official] realize how little flexibility they have today versus other recessions," Manning says.

"For most Americans in denial, this is going to be a real wakeup call; you're going to hear more often about sacrifice and learning to live within a budget, whether it's at the household or government level," Manning adds.

White agrees that pumping up consumer lending "is not a sustainable approach. There's got to be a transition to where the consumer is saving more and spending less, and the spending is coming from either the industrial/business sector or government sector — using those consumer savings to build capital, whether it's a private-sector plant and equipment or social sector infrastructure. The change from a consumer-driven to more of an investment-driven economy has to be the long-run pattern for our economy."

The Unending Bailout

In the meantime, the current approach to the financial crisis lacks both predictability and credibility, two things the markets crave. The Citigroup windfall earlier this week demonstrated that the goal is not only to protect the system, but to prop up favored institutions. And the longer Treasury waits to formulate a coherent strategy, the longer the line of supplicants grows at its door.

"It started out with commercial banks, then insurance companies, then money market funds, then automakers," says Lerrick. "Why not state and local governments? Why not homeowners? Where do you draw the line?"

Until a line is drawn, we won't have any idea how much risk the government is willing to take, and what the bailout will cost. And according to research firm Demos, another $250 billion in adjustable-rate mortgages are poised to reset to higher monthly payments by the year's end.

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November 28

Malls, hotels next victims in new mortgage crisis

By MATT APUZZO, Associated Press Writer Matt Apuzzo, Associated Press Writer Thu Nov 27, 9:14 pm ET

WASHINGTON – The full scope of the housing meltdown isn't clear and already there are ominous signs of a new crisis — one that could turn out the lights on malls, hotels and storefronts nationwide.

Even as the holiday shopping season begins in full swing, the same events poisoning the housing market are now at work on commercial properties, and the bad news is trickling in. Malls from Michigan to Georgia are entering foreclosure.

Hotels in Tucson, Ariz., and Hilton Head, S.C., also are about to default on their mortgages.

That pace is expected to quicken. The number of late payments and defaults will double, if not triple, by the end of next year, according to analysts from Fitch Ratings Ltd., which evaluates companies' credit.

"We're probably in the first inning of the commercial mortgage problem," said Scott Tross, a real estate lawyer with Herrick Feinstein in New Jersey.

That's bad news for more than just property owners. When businesses go dark, employees lose jobs. Towns lose tax revenue. School budgets and social services feel the pinch.

Companies have survived plenty of downturns, but economists see this one playing out like never before. In the past, when businesses hit rough patches, owners negotiated with banks or refinanced their loans.

But many banks no longer hold the loans they made. Over the past decade, banks have increasingly bundled mortgages and sold them to investors. Pension funds, insurance companies, and hedge funds bought the seemingly safe securities and are now bracing for losses that could ripple through the financial system.

"It's a toxic drug and nobody knows how bad it's going to be," said Paul Miller, an analyst with Friedman, Billings, Ramsey, who was among the first to sound alarm bells in the residential market.

Unlike home mortgages, businesses don't pay their loans over 30 years. Commercial mortgages are usually written for five, seven or 10 years with big payments due at the end. About $20 billion will be due next year, covering everything from office and condo complexes to hotels and malls.

The retail outlook is particularly bad. Circuit City and Linens 'n Things have sought bankruptcy protection. Home Depot, Sears, Ann Taylor and Foot Locker are closing stores.

Those retailers typically were paying rent that was expected to cover mortgage payments. When those $20 billion in mortgages come due next year — 2010 and 2011 totals are projected to be even higher — many property owners won't have the money.

Some will survive, but those property owners whose loans required little money up front will have less incentive to weather the storm.

Refinancing formerly was an option, but many properties are worth less than when they were purchased. And since investors no longer want to buy commercial mortgages, banks are reluctant to write new loans to refinance those facing foreclosure.

California, New York, Texas and Florida — states with a high concentration of mortgages in the securities market, according to Fitch — are particularly vulnerable. Texas and Florida are already seeing increased delinquencies and defaults, as are Michigan, Tennessee and Georgia.

The worst-case scenario goes something like this: With banks unwilling to refinance, a shopping center goes into foreclosure. Nobody can buy the mall because banks won't write mortgages as long as investors won't purchase them.

"Credit markets have seized up," corporate securities lawyer Michael Gambro said. "People are not willing to take risks. They're not buying anything."

That drives down investments already on the books. Insurance companies are seeing their stock prices fall on fears they are too invested in commercial mortgages.

"The system has never been tested for a deep recession," said Ken Rosen, a real estate hedge fund manager and University of California at Berkeley professor of real estate economics.

One hope was that the U.S. would use some of the $700 billion financial bailout to buy shaky investments from banks and insurance companies. That was the original plan. But Treasury Secretary Henry Paulson has issued a stunning turnabout, saying the U.S. no longer planned to buy troubled securities. For those watching the wave of commercial defaults about to crest, the announcement was poorly received.

"He's created havoc in the marketplace by changing the rules," Rosen said. "It was the stupidest statement on Earth."

The Securities and Exchange Commission is considering another option that might ease the crisis, one that would change accounting rules so banks don't have to declare huge losses whenever the market declines.

But the only surefire remedy is for the economy to stabilize, for businesses to start expanding and for investors to trust the market again. Until then, Tross said, "There's going to be a lot of pain going forward."

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