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Foreclosures are key element missing in plan

Hard as it is to believe, even a $700 billion bailout may not be enough to dig the economy and financial markets out of the hole they're in.
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Hard as it is to believe, even a $700 billion bailout may not be enough to dig the economy and financial markets out of the hole they're in.

By committing such a staggering sum to end the widening financial crisis, Congress and the White House are hoping to deliver a swift knockout punch to the fear gripping the global markets and economy. But to win bipartisan support, key provisions have been watered down or left vague — including any efforts to stop the wave of foreclosures at the heart of the meltdown.

Much of the debate — and opposition to the plan — centered on Treasury Secretary Henry Paulson’s original request for sweeping powers to spend hundreds of billions of taxpayer dollars on mortgage-backed securities that are unable to attract other buyers.

Opponents of the Treasury's original three-page proposal who balked at the lack of oversight have won provisions that place controls over the purchase process.  The plan involves creation of a Financial Stability Oversight Board that includes Federal Reserve Chairman Ben Bernanke, which will report regularly to a newly created congressional committee. Details of individual transactions involving taxpayer dollars will be disclosed.

The hope is that after the government jump-starts the market with massive purchases of the riskiest paper, private investors will follow, unfreezing trillions of dollars in capital that has fled to safety until the full scope of the crisis can be determined.

But it's not clear exactly how the mechanics of the plan will work; some of those details are still being finalized. Too much oversight could slow the government response — market panics don’t wait for government hearings. Treasury officials on a conference call with reporters Sunday deflected questions on “implementation.”

As the government begins to buy distressed investments, the hope is that a market price will allow banks and other financial firms to get a better idea of the value of bad paper on their books. But if the new “market” price is lower than the value already assigned these assets, another round of bank losses could follow.

So the bailout bill includes a safety valve. The Securities and Exchange Commission has the authority to suspend so-called “mark to market” accounting rules, so banks would not necessarily have to recognize those losses immediately.

Other provisions — left over from the yearlong debate over this summer’s housing relief bill — were also revived in the current plan. With taxpayer money in harm's way, Congress succeeded in putting a cap on pay packages for executives at companies that take advantage of the bailout.

That has plenty of loopholes. Existing contracts on pay packages can’t be changed, and executives in charge of financial companies that get help from the bailout can only have their pay docked if they get fired or the company fails.

But the biggest unknown is whether the government’s pledge to help homeowners at risk of losing their homes will be any more effective than past efforts to slow the pace of defaults and foreclosures. Until that tide begins to turn, the housing market will continue to be bloated with big inventories of bank-owned houses put back on the market at fire-sale prices. That puts downward pressure on all home prices. And until home prices stabilize, it’s impossible to assign a value to the troubled investments at the heart of Wall Street's problems.

Under the plan, the government is promising to work with companies collecting mortgage payments to encourage them to accept lower payments from troubled homeowners. Treasury officials say they think they can use the leverage the government will gain once it owns troubled mortgage-backed securities. But that promise may be fundamentally flawed.

The government's basic plan is to buy just the worst securities in huge mortgage pools, which won't give the Treasury control over all the mortgages in that pool.

The problem that has stalled foreclosure relief efforts to date is rooted in how these mortgage-backed investments are structured. By pooling hundreds of mortgages in a separate entity, and then using the payment stream to back multiple classes — or tranches — of investments, Wall Street’s alchemy turned risky subprime borrowers into Triple-A rated safe investments.

To do so, Wall Street bankers assigned different prices, and different levels of risk, to those tranches, creating a so-called "waterfall.” The current mortgage default rate of about 9 percent means only the investors at the bottom of the waterfall are getting wiped out. The problem is that until the mortgage default rate begins to fall, no one knows how far up the waterfall investors will be hurt.

For investors higher up the ladder, there is no incentive to accept lower interest rates.

Treasury officials Sunday night said they expect the bailout fund may be used to buy up mortgages directly, or buy entire pools of mortgages. But after nearly a year of prodding lenders and services to rewrite loan terms voluntarily, it remains to be seen how effective the Treasury will be in its efforts to — in the legislation language — “encourage” loan servicers to “minimize foreclosures.”

For the past year, many House Democrats have been urging that the process of rewriting unsustainable loans be turned over to bankruptcy judges. That proposal was hotly debated again during the whirlwind negotiations of the past week.

Opponents — including The White House and some Republicans — argued that forcing lenders and investors to accept such bankruptcy “cramdowns” would only make matters worse. They argue that lenders would be leery of extending new credit if borrowers could go to court to have terms changed. That would make mortgages more costly and more difficult to get, worsening the housing crisis, say opponents.

Supporters of the bankruptcy law change argue that voluntary efforts to work out affordable loan terms — including the White House’s highly touted Hope Now Alliance — just haven’t worked. They also note that the bankruptcy process applies to other forms of debt that are still in relatively good supply.

In any case, unless anticipated future loan “resets” to unaffordable payments can be diffused, the pace of mortgage defaults and home foreclosures likely will be difficult to contain.