Uncle Sam Nears a Massive Banking, Housing Bailout

The Fed's help for Bear Stearns is just the latest move to stabilize the financial system and prop up the housing market.

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Of course, the irony of today's Federal Reserve bailout of investment bank Bear Stearns is that the firm has a reputation as being among the most free-market loving on Wall Street—and that's saying something about a company located smack in the middle in America's financial capital. But just as there are no atheists in foxholes, there are no libertarians during financial crises, at least not if it's their dough at stake. And while there are plenty of economists out there who are advocating a hands-off approach to the credit crisis and housing implosion—echoing Andrew Mellon's infamous advocacy of "liquidate...liquidate...liquidate"—they will be disappointed. Uncle Sam will probably continue to intervene during this financial turmoil.

And not just the Fed. More and more, it looks as though Congress, followed by a reluctant White House, will move ever more boldly to stop the hemorrhaging in housing and unfreeze the credit markets. Richard Bove, banking analyst at Punk Ziegel, says in a note this morning that it's "more certain than ever" that there will be a housing bailout to stop the increasing rate of foreclosures and the continuing drop in home prices. And political analyst Alec Phillips of Goldman Sachs says that he sees "a high likelihood that some type of housing measure is enacted this year." Most of the legislative energy seems to be swirling around a plan put forward by Democratic Rep. Barney Frank. The plan, as outlined by Bove:

• FHA provides up to $300 billion in new guarantees to help refinance at-risk borrowers into viable mortgages.

• The terms of the first mortgage are set at a level that the borrower can afford.

• A second mortgage is put in place, which pays off on sale of the house and allows the government to recover the losses absorbed by creating the first mortgage at below market rates.

• The existing lender agrees to accept a reduced payment, which could be substantial since the new loan is based on the house's current appraised value.

• Gets the existing lender free of all obligations and exposure to the borrower.

• Refinance between 1 and 2 million homes.

• Provide funds to refurbish empty homes and put them back on the market.

Phillips thinks that while President Bush might prefer a more free-market approach, the White House is "not likely to come out strongly against the proposal initially. Given our expectation for Democratic gains in the upcoming election, such proposals are likely to become law by mid-2009 in the event that they fail to gain support this year. For this reason, Republicans may seek a compromise in 2008."

Indeed, President Bush has almost gone out of his way not to rule out a bailout. Nor did he do so in a speech to the Economic Club of New York this morning. And in an interview on CNBC today with Lawrence Kudlow, the president basically said that in extraordinary situations, extraordinary action is required.

Now, don't expect a financial miracle or a relaunch of the housing boom here. Instead, a bailout would give clarity to investors by shifting the price and foreclosure risk of the tumbling housing market to the government and taxpayers. Bove, who has been advocating a plan like Frank's, thinks passage would be great news for homeowners and the credit markets:

This program will work. It makes sense. It penalizes the bad lenders. It allows the householder to stay in the home and forces him/her to pay the government at the time of sale for its initial losses. It allows the holders of structured financial securities to be paid off and reestablishes the credibility of these securities. It cleans away the financial garbage that is now depressing the markets. It provides a solution to the empty housing dilemma. Plus, and this is important, it creates a format that can be used by the private sector to rid itself of the troubled loans without government getting involved. Big banks can do this without the government's aid. This idea is as brilliant as the Fed's securities swap idea. Clearly I am biased in reviewing this proposal because it is one that I have been advocating for months in almost the exact same format. If this gets through Congress the financial crisis is definitely over.

And there are other ideas floating around as well. Nobel laureate and financier Myron Scholes wants the government to inject capital into the banking system by investing in debt and stock. International Monetary Fund official John Lipsky, a Wall Street veteran, also thinks the government may need to put taxpayer money directly into banks. And Vincent Reinhart, the Fed's former chief monetary economist, told Bloomberg that the Fed is inching closer to buying up those beaten-down mortgage-backed securities.

Are any of these suggestions likely to happen? Today's move by the Fed, using a little-used Depression-era provision of the Federal Reserve Act, makes previously unlikely actions seem far more possible.