To fix U.S. credit mess, timing is critical
Risks rise if the Federal Reserve and Treasury move too slow – or too fast.
By Mark Trumbull | Staff writer of The Christian Science Monitorfrom the March 11, 2008 edition
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Amid a financial crisis, America's top economic officials are trying to walk a fine line: Help avoid a meltdown, but don't stand in the way of self-correction by the marketplace.
The stakes are high for an economy now on the edge of recession – or already in it.
To a degree, the challenge boils down to a question of speed. Some experts say policymakers should try to slow down the pace of credit-market carnage, or America could face a job-destroying vortex where people have to sell investments, even entire companies, at fire-sale prices. Others say banks should get bad loans out in the open as quickly as possible and that delay will only make the credit mess worse.
Since both approaches hold risks, policymakers may be trying to chart an in-between course.
"The logic of finding a middle way is obvious," Nouriel Roubini, an economist at New York University, told a congressional hearing recently. But "finding the right and appropriate 'middle way' ... is very hard."
America's credit markets are clearly crying out for help. Some companies confront sudden "margin calls" to repay loans they once took for granted. Even typically boring investments – municipal bonds and Fannie Mae mortgage bonds – have had a wild ride in recent days.
Such chaos has surfaced on and off for a year, and federal agencies haven't been able to contain it. Instead, the credit climate has shifted from a flood of money to a lending drought. The key problems: fear, frayed confidence, and uncertainty about the proper value of loan-related investment products.
The Federal Reserve and US Treasury are making the credit situation a round-the-clock priority. Some of their recent policies blend a "slow" and "fast" approach.
On Friday, the Federal Reserve said it would boost to $100 billion the short-term loans available to banks this month. The Fed will make another $100 billion available to a range of other financial players.
Also, the Fed has cut short-term interest rates sharply since September and has been signaling that further cuts are likely at its next policy meeting next week.
These moves, analysts say, are designed to give financial firms some breathing room as more bad loans pile up on their balance sheets. A fall in short-term interest rates tends to bolster bank finances, since it widens the spread between what it costs banks to borrow and what they charge when they lend.
The interest-rate cuts also could help many homeowners avoid defaulting on their loans. Had the Fed not eased rates, some $250 billion worth of home mortgages would have seen adjustable rates reset higher, with the interest rates on 40 percent of those loans jumping by at least two percentage points, according to a report by Moody's Economy.com in West Chester, Pa.
Factoring in expected rate cuts, it's possible that almost no mortgages would adjust upward by more than two percentage points, the report says.
At the same time, Fed Chairman Ben Bernanke has tried to convince bankers to deal with problem loans at a faster pace. The Treasury Department has also urged that banks and other lenders modify as many risky loans as possible, easing terms so that fewer borrowers will default.
But so far, banks have not moved as decisively as the Bush administration had hoped. In his speech last week, Mr. Bernanke reiterated the idea with a new twist: He said banks should mark down the principal balance on loans to reflect current market values.
That way, a homeowner who was "under water" – owed more on her house than it's worth – would have her mortgage reduced to a more realistic level. According to Economy.com, about 10 percent of homeowners are now under water. They have been the most likely to default on their mortgages.
"When the mortgage is under water, a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure," Bernanke said.
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