U.S. Mulls Next Steps in Crisis

Bipartisan Goal The swiftness and virulence of the financial problems have been stunning. The problems are rooted in a bipartisan goal to figure out ways for lower-income Americans to buy homes, so that they could build financial wealth and plant deep stakes in their neighborhoods. But the instruments that mortgage companies devised included provisions -- interest resets after five years, no down payments -- that buyers didn't fully appreciate could backfire. When those subprime mortgages were bundled into packages of debt and sold to a daisy chain of interlocked financial institutions, the risks of those provisions eluded investors considered far more sophisticated than first-time home buyers. Essentially, the risks were hidden from view -- "a lack of transparency," financial types call it. The irony is that the U.S. and the International Monetary Fund have been lecturing developing countries since at least the 1980s of that very danger. If economic risks aren't transparent to investors, they're likely to blow up, and can drag down an economy. That's happened repeatedly in Latin America and in the late 1990s in Asia and Russia. Now the U.S. is wrestling with questions that have long dogged other nations. Who should be bailed out? Who bears the cost? What is the role for the central bank? How should markets be regulated to avoid a repeat of the problems? Bigger Role of Government Chairman Ben Bernanke has also been faster than the Bush administration to embrace a bigger role for the federal government in resolving the crisis. A few weeks ago, he argued that the FHA should be allowed to guarantee more delinquent mortgages as a carrot to private lenders to write down the value of those mortgages without foreclosing on the homeowners. Mr. Bernanke, a Republican, isn't ideological. From his long studies of the Great Depression he concluded that event could have been prevented had the Fed shown more leadership. And he credits the Depression's end to the creativity of President Franklin D. Roosevelt. In 2000, he advised Japanese policy makers struggling with that country's long malaise to emulate FDR. "Many of his policies did not work as intended but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done," he wrote. Indeed, the goal of U.S. policy makers is to avoid the malaise that gripped Japan for a decade after its banks accumulated vast sums of bad debt following the burst of a late-1980s bubble in real estate. When land prices collapsed, so did the value of the real-estate collateral that backed most loans, leaving many borrowers unable to repay and saddling Japanese lenders with trillions of yen in bad loans. Financial authorities waited years for the bad loans to fade away without government action. But the problem only started to lift after the government, starting around 1998, began injecting huge amounts of public funds in the hobbled banks. It took until around 2005 for the banks to clear up the worst of their bad loans and for the first time in nearly a decade report rises in their loans outstanding. The U.S. turmoil so far doesn't look nearly as intractable as Japan's, and so far President Bush and Treasury Secretary Henry Paulson have emphasized voluntary industry efforts to renegotiate troubled loans, along with a limited expansion of federal housing finance programs. Although Messrs. Bush and Paulson say they're open to other ideas, they have also made clear that they haven't yet heard a plan that they think would work to address the wave of home foreclosures now sweeping the nation, and the financial turmoil that the housing problems have spawned. The Same Issues The U.S. will face the same issues that Asian nations faced in the crisis of 1997-98. Is it better to nationalize financial firms outright, or inject bonds that provide the funding to carry on, so long as the recipients agree to repay the bonds with future profits? Glenn Hubbard, a former Bush White House chief economist who is now dean of the Columbia University's business school, says regulators should pay more attention to financial sector liquidity than they have in the past. But he's fearful that detailed regulation of specific financial instruments could backfire. The system is so complicated, he says, that it's hard to know what the consequences will be. Inadvertently, regulators could "diminish risk-taking among prudent investors and increase risk-taking by the clever." Other Possibilities Other possibilities include increasing tax-exempt bond authority, changing bankruptcy laws, reducing principal balances for underwater loans or issuing so-called "negative equity certificates." Under the latter, Treasury's Office of Thrift Supervision proposed that banks reduce mortgage balances to help homeowners hang onto their houses, but receive in exchange certificates that would give them rights to any windfall profits should the house value rise again. Mr. Paulson hasn't indicated that he would support the plan.