Paul Krugman Does a Hail Mary Pass

Yves Smith of Naked Capitalism submits:

The estimable Paul Krugman, in his regular New York Times op-ed column, tells us (subscription required) that mortgage borrowers in the US are feeling a world of hurt. The pain is moving up the food chain beyond stressed subprime borrowers into the Alt-A pool (which truth be told, never was much stronger than the subprime cohort, so this development was anticipated). And he argues that "widespread malfeasance" was a big part of the problem, depicting the rating agencies as enablers, much as the major accounting firms were in the Enron and World Com scandals.

So far, fair enough. But then we get to this:

Yet our desire to avoid letting bad actors off the hook shouldn't prevent us from doing the right thing, both morally and in economic terms, for borrowers who were victims of the bubble......Consider a borrower who.... is facing foreclosure. In the past,....the bank that made the loan would often have been willing to offer a workout.....

Today, however, the....mortgage was bundled with others and sold to investment banks, who in turn sliced and diced the claims to produce artificial assets..... And the result is that there's nobody to deal with.

This looks to me like a clear case for government intervention: there's a serious market failure....The federal government shouldn't be providing bailouts, but it should be helping to arrange workouts....

The mechanics of a domestic version would need a lot of work, from lawyers as well as financial experts. My guess is that it would involve federal agencies buying mortgages -- not the securities conjured up from these mortgages, but the original loans -- at a steep discount, then renegotiating the terms. But I'm happy to listen to better ideas.

Lordie. First, I have to differ with Krugman's premise. Borrowers should NOT be rescued wholesale from having participated in a real estate bubble. That is no different that being rescued from participating in a stock market bubble (oh wait, we did sort of do that, via Greenspan dropping interest rates to 1%. But events of last week have shown that wasn't such a hot idea after all). Yes, there was fraud perpetrated by both lenders and borrowers. And when the lenders defrauded borrowers via inadequate or misleading disclosure, I'm all for ways to rescue the borrower and make the perps pay.

But Krugman is talking about a massive rescue, of the hapless, the greedy, and even the fraudsters. And he airly waves his magic wand and says the government should step in and buy mortgages and arrange workouts.

This is a Herculean task. It wouldn't simply require a massive rewriting of lots of rules. To cut through the Gordian knot of the complexity of the disposition of mortgage paper (much of it went into collateralized debt obligations, which were resecuritized and sold in tranches, which then sometimes would up as constituents of yet other instruments, such as "CDO squared" (CDOs of CDOs) or "CDO cubed" (CDOs of CDOs of CDOs) or synthetic CDOs (the cashflows from writing protection via credit default swaps on CDOs would be aggregated, tranched, and sold as a new CDO) is impossibly difficult to achieve via modification of specific deals, or rules around particular deals. (And I'm not going to get into what it would take to create a new Federal effort to renegotiate the loans it acquired. Remember the Resolution Trust Corporation of the S&L crisis? All they did was buy bad bank assets and sell them wholesale at the best price they could get. That was still a very big undertaking, but Krugman's effort would require large scale hiring of banker types to negotiate loans individually.)

You'd need an expropriation of assets. And that would constitute such a major violation of property rights and contractual law as to call into question the viability of the US as a place to sell securities.

But to his credit, Krugman's proposal would have the salutary side effect of scaring an entire generation of financiers away from designing and selling funky paper.

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