Less than the Least

As Obama, Clinton, and everyone else tout their remedies for the subprime crisis, I’m reminded of the old joke about a group of blind men who encounter an elephant. The man who grabs the elephant’s leg tells the others he has encountered a tree, the one who touches the trunk is sure it’s a huge snake, and so on. In the fall, subprime worries centered on the losses that banks were suffering, and the possibility that credit markets would seize up. Now the homeowners who are facing default are on center stage.

These parts are connected in ways that often get obscured.

Fed Chairman Ben Bernanke has now called on banks to forgive portions of the principal owed by struggling subprime borrowers, which suggests that a major intervention may be coming. As between jawboning (the Republican inclination) and a bailout (the Democrats’ leaning), I’ll take jawboning any day. But the third option, amending the bankruptcy laws to allow borrowers to reduce their mortgages, is, in my view, much superior to either, as I argued in a post last week.

Rather than repeat those arguments, I’ll simply add two additional points.

Shortly after I learned of Spitzer’s resignation, I was at dinner with
several Italian lawyers. At the table next to us at a lovely restaurant
near the Trevi Fountain sat the leading director of soft core porn
movies in Italy. (Note to wife: I didn’t recognize the director, my
companions did). The Italian lawyers were puzzled that resignation was
the obvious response to a sex scandal in the U.S. The Italian public
wouldn’t be especially alarmed about this kind of revelation, they said:
they expect it from their politicians.

Bill speculated several days ago that prosecutors’ use of criminal law to pursue the executives of firms that go spectacularly bust may often serve no other purpose than to discourage firms from engaging in the kinds of risks that make a market economy go. I for one think that this is a very real danger. Executives who commit crimes should be punished, of course, but often prosecutors seem to identify the targets in high profile cases first, and then start looking for criminal provisions to prosecute them with.

There are two problems with this, in my view.

Many of Bear Stearns’ biggest shareholders are screaming about its proposed sale to JPMorgan for $2/share. This is a good sign. It is important that shareholders bear the costs of the bank’s missteps in the subprime market. But their squawking also raises at least two questions: can they derail the deal?; and would Bear Stearns be better off in bankruptcy?

Hillary Clinton has just rolled out her most extensive recipe yet for addressing the subprime crisis. The plan, which includes $30 billion to purchase troubled mortgages and for foreclosure auctions, as well as a freeze on foreclosures and interest rates, is striking in two respects: 1) although the plan is wrapped in populist appeals to struggling homeowners (of whom we have many here in Pennsylvania), it seems nearly as attractive to big banks and other lenders; and 2) there’s nary a word about reforming the bankruptcy laws, a much more sensible way to help out homeowners. I suspect these two things may be related.

As the Bush administration begins its defense of the new Treasury Department proposal to revamp U.S. financial regulation, Democrats are arguing, rightly in my view, that the more urgent concern should be to directly address the mortgage crisis. Unfortunately, Democrats increasingly are coalescing around a proposal by Congressman Frank and Senator Dodd to pump billions of dollars into the Federal Housing Administration to guarantee new mortgages that would replace troubled borrowers’ current mortgages. Proponents cite the Home Owners’ Loan Corporation, which was set up at the outset of the New Deal, as shining precedent for the Frank-Dodd plan.

The HOLC certainly sounds like a remarkable governmental success story.

Almost a year into the subprime crisis, we still haven’t seen any major reforms. The Enron and WorldCom scandals six years ago, by contrast, prompted sweeping reforms in Congress and on Wall Street. Why the difference?

I increasingly think the most important difference is the lack of a clear villain– a person and company that serve as a posterchild for everything that is wrong and needs to be fixed with American finance.