Financial crisis and the housing market: Dodging the issue

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This crisis is only going to end when the root cause of the problem – the housing market – is fixed.

When Citigroup announced on November 24 that it had struck an agreement with the US government to isolate some of its most distressed assets, it was a stark reflection of the haphazard and indiscriminate nature of the federal response to this crisis.

If carving out bank balance sheets to create good banks and bad banks sounds alarmingly familiar, that’s because it is. Isn’t that what was suggested for the monoline insurers nearly a year ago? Isn’t that what Lehman Brothers was proposing to deal with its real estate exposure shortly before it imploded? Isn’t that kind of what the original Troubled Assets Relief Program (Tarp) was supposed to do?

Under the rescue plan for Citi, a pool of $306 billion of troubled assets has been identified for which the Treasury, the Federal Reserve and the Federal Deposit Insurance Corp will mop up losses over and above $29 billion. Coming just days after Treasury secretary Hank Paulson announced that Tarp would no longer be used to buy troubled assets from the banks, it sent – at best – a somewhat confusing message as to just what the US government thinks is needed to fix the markets.

Given that governments around the world have thrown everything they have at this crisis for 18 months (with precious little to show for it) it is hardly a surprise that they have arrived back at the root cause of the crisis – the assets themselves.

It took the Resolution Trust Corp (RTC) to sort out the Savings & Loan mess and the Home Owners Loan Corp and Resolution Finance Corp to drag the US out of the depression of the 1930s. So suggesting that some sort of bad bank mechanism might be in order now is hardly revolutionary. The problem is that RTC simply received assets from defunct depository institutions – it was not trying to ‘buy’ them to stave off those institutions’ failure. Despite the obvious challenges associated with the latter approach, it is now increasingly clear that this is the path that the authorities will have to take. The Citi deal involves the government guaranteeing, not buying, assets. And the announcement of the Term Asset-Backed Securities Loan Facility (Talf) on November 25 involves the provision of federal financing to investors in ABS rather than the government itself buying the securities. And the Talf proposal only relates to new and recently originated loans, not the problem assets that Tarp was originally targeting.

A recent statement by Nicholas Brady, Eugene Ludwig and Paul Volcker declared that, "the pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to devour the next weakest link". This has been seen time and again. The only way to deal with it from strength is to shore up what caused it in the first place – real estate.

Stabilizing foreclosures, guaranteeing new mortgage lending and removing securities backed by toxic mortgage loans from the banking system could – maybe – achieve this. Simply throwing money at the banks and hoping the market will sort itself out won’t.