Q and A: Can Washington end the financial crisis?

McClatchy NewspapersSeptember 18, 2008 

WASHINGTON — Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke met congressional leaders Thursday night to discuss additional steps to end the widening global financial crisis by creating a mechanism for the government to purchase mortgage bonds that no one else wants.

Stocks roared back to life Thursday on the news that Paulson was devising a plan to create something like the Resolution Trust Corporation, which took over bad real estate loans from failed savings-and-loans during the 1980's and early '90s, and eventually sold them off.

Officials at the Treasury and the Federal Reserve wouldn't discuss the evolving plan, but they didn't shoot down talk of such an effort. President Bush canceled a scheduled fundraising trip Thursday to monitor developments.

"The American people can be sure we will continue to act to strengthen and stabilize our financial markets and improve investor confidence," the president said.

Here are some answers to questions about how such a government mechanism might work.

Q: What was the Resolution Trust Corporation, and why are people talking about it now?

A: In the aftermath of the savings-and-loan crisis of the 1980's, Congress created the RTC as a government-owned asset management company. It was asked to sell off the assets, many of them real estate holdings, of thrifts that the Office of Thrift Supervision had declared insolvent. Bert Ely, an expert on the S&L bailout, estimates that the S&L crisis cost taxpayers about $124 billion. The potential cost of the current crisis is much larger.

Q: Is this a new idea for solving the current crisis?

A: Former Treasury Secretary Nicholas Brady, who was in office when the RTC operated, and former Fed Chairman Paul Volcker advocated this idea on Wednesday. In an opinion piece in The Wall Street Journal, they called for the creation of a government body to buy up bad mortgages and get them off the books of troubled banks.

"We are in the midst of the worst financial turmoil since the Great Depression. Absent bold action, matters could well get worse," they warned, adding that, "Crisis times require stern measures."

As the Fed chairman in the early 1980s, Volcker raised interest rates to choke inflation out of the U.S. economy. Brady helped end the Latin America debt crisis during the 1980's with a program that bought bad debt and repackaged it as bonds that later became known as Brady bonds.

Q: How would this work?

A: The idea is to get toxic mortgage bonds, which are often backed by sub-prime loans to the weakest borrowers, off lenders' books. The federal government would purchase the bonds at a deep discount, perhaps a dime on a dollar of face value. This would remove a huge cloud that's hanging over banks and other lenders, but it's not entirely clear whether it would help stabilize housing markets quickly, because mortgage finance remains in crisis.

Here's why it might not work. Unlike the S&Ls of the 1980s, banks rarely hold a mortgage on their books today. Instead, they sell it into a secondary market, where it's pooled with other mortgages and sold as a mortgage-backed security, which is like a bond.

Fannie Mae and Freddie Mac issue the safest of these bonds, which are backed by prime loans given to the healthiest borrowers. However, the Treasury Department seized these two government-chartered, privately operated companies on Sept. 6.

Riskier loans, the cause of the housing meltdown, were packaged and sold by the investment banks that are now dropping like flies. In simple terms, the secondary market where mortgages traditionally have been purchased has been in a state of paralysis.

The hope is that once the bad loans are purged from the system, this secondary market will bounce back to life. That's far from certain.

Q: Are there other benefits to this plan?

A: When the Federal Reserve helped broker the sale of investment bank Bear Stearns in March, it took possession of some of these toxic mortgage bonds. So there's a blueprint of sorts, and creating a new RTC-like institution would free the Fed to do what it normally does, fight inflation and promote employment.

Having the government take control of these mortgage bonds also would create a more orderly liquidation process. Over a longer period of time, these bonds might regain some value, and their sale could help offset some of the upfront costs to taxpayers.

Q: What does all this mean for homeowners?

A: In theory, this would help keep homeowners from foreclosure if it includes modifying loans that have been pooled into mortgage bonds. In such a scenario, there'd be fewer foreclosures, which would help prevent a deeper downturn in housing prices, especially in neighborhoods that already are experiencing more foreclosures. Again, however, details aren't available yet.

Q: Hadn't this been discussed before?

A: Yes. It was talked about in August 2007, when the housing crisis started becoming a broader financial crisis. Bill Gross, the chief investment officer and co-founder of Pacific Investment Management Co., the nation's biggest bond fund, called on President Bush to bail out homeowners by purchasing troubled mortgage bonds.

"Write some checks, bail 'em out, prevent a destructive housing deflation," he wrote in words that proved prophetic. "This rescue, which admittedly might bail out speculators who deserve much worse, would support millions of hard-working Americans whose recent hours have become ones of frantic desperation."

Congressional Republicans and some Democrats opposed this idea, saying it would reward homeowners who'd bitten off more than they could chew. Those in favor, such as Gross, suggested that the idea could prevent a much deeper housing problem, which is what followed.

More from McClatchy:

Financial shock ripples around globe

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Poll: Americans think economic problems will get worse

To ask a question about this story or any economic question, go to McClatchy's economy Q&A

McClatchy Newspapers 2008

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