Easing Financial Market Stress

Brad DeLong makes a proposal for dealing with financial market troubles (complete with graphs). His proposal differs from the proposal in the post below this one in two ways. First, the government buys mortgages directly rather than mortgage backed securities, then reissues those mortgages at more attractive rates. Second, Fannie Mae rather than the Fed purchases the assets since that is the fastest way to put the mortgage purchase plan into action.

Would this prevent defaults and foreclosures? If so, and if this restored confidence in financial markets, then there would be no reason for the Fed to do as I proposed and remove risk from the market by purchasing risky mortgage backed securities (since they would no longer be as risky).

I think purchasing mortgages would help to stabilize the mortgage market, so I am also in favor of the mortgage purchase plan, particularly since it helps homeowners directly. I am just not sure that it will be enough by itself to get credit flowing again. Loan characteristics are different today, e.g. they are longer, so the experience of the past may not be a very good predictor of what will happen this time around. Because of the uncertainty about whether purchasing mortgages will be enough to stabilize markets, I would advocate doing a combination of both policies, purchase troubled mortgages and purchase troubled financial assets at the same time, particularly since the purchase of financial assets can be put into place very quickly, an important consideration (and other measures, e.g. regulatory change, could also be put into place so his is not all that can be done).

On mortgage purchase plans, or any sort of bailout, I think it's important to remember what Richard Green said. From an earlier post on Alan Blinder's proposal to reintroduce the HOLC:

 Richard Green adds:

Alan Blinder and Mark Thoma want to bring back the HOLC, by Richard Green: ...I am myself a fan of the HOLC, and have said so in articles I wrote with Susan Wachter for Journal of Economic Perspectives and for the Jackson Hole conference last summer, as well as a comment I just wrote for Housing Policy Debate. Yet I am not sure it is alone the medicine for the current crisis.

When the Home Owners Loan Corporation was invented, it was in response to an economic tsunami that swamped lenders and homeowners. Moral hazard was not much of an issue, as loans were stringently underwritten (typical LTVs were 50 percent at origination). But loans had short terms, and therefore were vulnerable when people were forced to refinance in the teeth of the great depression. The HOLC allowed for massive loan modification and helped get incentives for borrowers and lenders aligned correctly.

Now, however, we are in the midst of a crisis that has arisen in part because of agency problems throughout the lending chain. To bail out lenders through some sort of HOLC setup could very well encourage excessive risk taking in the future, which is of course problematic.

I think if we are going to go the HOLC route, it needs to be accompanied by a regulatory structure that will prevent the sort of bad practices that led to the current crisis going forward. As I have noted before, such regulatory changes would require greater transparency, a requirement that everyone who touches a mortgage be subject to federal supervision, and a requirement that everyone who touches a mortgage have some capital at risk.

[Update: More on the HOLC.] [Update: For more on the international spillovers and recommendations for regulatory reform, see Reflections on the International Dimensions and Policy Lessons of the US Subprime Crisis," by Carmen M. Reinhart, Vox EU]