In late October 1907, the American financial system appeared to be on the verge of collapse. The trouble had begun with a seemingly minor event—a failed attempt at stock-market speculation by a bank owner named F. A. Heinze—but it spread quickly after news of Heinze’s losses prompted a run on his banks by worried depositors.
In a matter of days, financial institutions with connections to Heinze were facing similar withdrawal frenzies, and the stock market was falling precipitously. Amid the turmoil, the financier J.P. Morgan stepped in. Consulting with the Treasury Department, which committed millions in deposits to weak banks, Morgan browbeat bankers into bailing out struggling institutions, funnelled money to cash-starved brokers and even convinced clergymen in New York City to dedicate their Sunday sermons to the need for “calmness and confidence.”
Within a few weeks, the fear and chaos had subsided, and the “panic of 1907” left only a small dent in the U.S. economy. A hundred years later, in the midst of what you might call the panic of 2007, many investors are hoping that a Morgan-style rescue plan will have similarly beneficial effects. The plan, which was unveiled last Thursday, after weeks of orchestration by Treasury Secretary Henry Paulson, seeks to stabilize the chaotic subprime-loan market by freezing the interest rates of some borrowers.
Although Paulson works for the government, his scheme involves no action by the state. Instead, he has relied, much as Morgan did, on collective suasion, assembling representatives of the many parties involved—mortgage lenders and servicers, investors who bought mortgage bonds, and borrowers—and pushing them toward a solution that, in theory, will leave the economy better off.
The plan targets a looming crisis. Many subprime mortgages came with so-called teaser rates—interest rates that start out low but quickly reset to become significantly higher. Many of those loans—more than $350 billion worth, in fact—are going to reset next year. That means that hundreds of thousands of people who are currently able to pay their mortgages are about to see their payments rise by hundreds of dollars a month.
If the credit and housing markets were more buoyant, these people might be able to refinance their loans or sell their homes. But the sharp decline in housing prices and the tightening of credit standards has closed off those options for most subprime borrowers, which pretty much guarantees a big increase in the number of foreclosures. The Paulson plan is meant to buy borrowers—and, arguably, the economy—some time, by postponing the interest-rate resets for five years.
Not for everyone, though. The plan sets up a system of triage, separating borrowers into three categories: Those who will be able to keep paying after the rates reset, or else refinance their loans; those who can pay now but won’t be able to when the rates go higher; and those for whom even the current rates are too high. Only the second group will get help. Also, the plan doesn’t go into effect until next year—if your loan resets on Dec. 31, you’re out of luck.
In theory, this solution is one that lenders could have arrived at on their own. Lenders often lose less money on a renegotiated loan than on a foreclosure, so they should be well equipped to triage bad loans, separating the workable from the truly hopeless cases.
So why did the government need to get involved? One reason is that so many loans are going bad that the companies servicing them don’t have the people or the skills to evaluate them on a case-by-case basis. (A recent study found, for instance, that mortgage servicers renegotiated only 1 percent of loans that reset in the first part of this year.)
And, because most of these loans have been packaged into securities and sold to outside investors, the process of renegotiating mortgages is now far more complicated than just talking to the loan officer at your local bank. Paulson’s plan streamlines and simplifies the process by creating rough-and-ready definitions of creditworthiness.
The Treasury Department’s sponsorship also permits a degree of collusion that might normally be considered illegal—banks aren’t typically allowed to work together to set loan prices. And it reduces, although it certainly doesn’t eliminate, the risk that the investors who actually own these mortgages will sue to prevent the wholesale renegotiation of the loans they own. It’s a powerful example of the way government can shape markets without ever passing a law or a new regulation.
Unfortunately, it’s also an example of the limits of such intervention. Although the plan will provide real relief for at least some homeowners, it’s more like a Band-Aid than like the major surgery that some of the hype makes out. That’s because at this point interest-rate resets are just a small part of the mortgage-market problem. Postponing rate resets doesn’t change the fact that too many people spent far too much borrowed money on houses with prices that were far too high, and that they are now stuck in homes that they can’t really afford and can’t sell.
Even with the interest-rate freeze, foreclosures will keep rising. More important, problems in the credit markets are no longer limited to subprime loans; rather, they involve a wholesale reëvaluation of risk, fuelled by a deep sense of distrust in the way the financial system rates and values assets like mortgages.
For these problems, there’s only so much that even the government can do. In 1907, J.P. Morgan was able to come to the rescue not just because he could get all the people who mattered into one room but because he was facing a clear problem with a clear solution. Those were the days.