Financial crisis crushes political consensus

By Steve Schifferes
Economics reporter, BBC News, Washington DC

As the meltdown on Wall Street deepened this week, with no end in sight, the political consensus in Washington seems to be evaporating.

The Federal Reserve's authority is being challenged

Up to now, politicians in both parties have been content to leave the short-term management of the crisis to the US Treasury and the Federal Reserve, whose emergency measures have so far stabilised the markets.

(Those politicians include President George W Bush, who has been notably absent from any of the decision making during the crisis).

But with the bill for the various rescue packages rapidly mounting, and the Treasury reversing its opposition to further bail-outs, Congress is moving to reassert control over decision-making.

The Democratic speaker of the House, Nancy Pelosi, has called for a urgent investigation into the causes of the crisis, and expressed her scepticism about the AIG bailout without Congressional approval.

And the mounting scale of the rescue has disturbed seasoned observers.

Let's make September 15 free market day - that's how long the 'no bail-outs' philosophy lasted Barney Frank, the chairman of the House Financial Services Committee

"These are massive amounts, and it is deeply troubling," says Senator Chris Dodd, chairman of the Senate Finance Committee.

On the right, Republican congressmen - such as Jeb Hensarling of Texas - are organizing to speak out publicly against further bail-outs, arguing that too much public money has been spent already.

"People are angry that because they see this as their tax dollars bailing out Wall Street speculators," says another sceptic, Republican Congressman Paul Ryan of Wisconsin.

Radical intervention

Meanwhile, key Democrats, such as House financial services chairman Barney Frank, are moving to consider radical proposals for much bigger Federal government intervention in the crisis.

The global financial crisis In pictures

With Wall Street on its knees, and the failure yet again of a private rescue plan promoted by Treasury Secretary Paulson at the weekend, they believe the time is right to consider a more systematic government approach to the meltdown.

"Let's make September 15 free market day," says Barney Frank, the chairman of the House Financial Services Committee. "That's how long the 'no bail-outs' philosophy lasted."

The new approach could involve a government agency to buy up the trillions of dollars of distressed mortgage-backed debts from banks - and also big changes in regulating the mortgage market, to force companies to restructure individual mortgage loans that are in distress, rather than foreclose them.

Some elements of such a plan would be supported by some moderate Republicans as well, such as Representative Chris Shays of Connecticut, and former Federal Reserve chairman Paul Volker and former Treasury Secretary Nicolas Brady.

But the process of working out the new policies has just begun, and it will be complicated by the election - with Congress recessing next week to return to their home districts to campaign - and the "lame duck" administration until the new President takes office in January.

Rescuing the housing market

The underlying cause of the banking crisis has been the sharp fall in US house prices, which is at the heart of the collapse in the value of the mortgage-backed securities that is troubling Wall Street.

With 1.5 million homes foreclosed, or repossessed, last year, and 1.2 million already in the first six months of this year, the glut of unsold property (equal to one year's supply of new building) is likely to further depress prices.

The financial crisis has become a political headache

The answer, Congress believes, is to reduce the volume of foreclosures and ensure that banks restructure delinquent loans instead.

Although Sheila Bair, chairman of the Federal Deposit Insurance Corporation, which takes over failing banks, says she is encouraging banks to consider restructuring loans rather than foreclosing, there is little evidence as yet that this is happening.

Congress has already created a $300bn mortgage rescue fund to supply the funding for such restructuring in the emergency housing bill passed at the end of July.

But the head of the agency that is setting up the mortgage fund, Brian D Montgomery, told Congress on Tuesday that it is unlikely to get much take-up of the special mortgages until the New Year, and even then it is sceptical that mortgage lenders will make much use of it.

Bailing out homeowners

The problem is that it is up to the banks to decide whether they want to take up the new facility - and since it requires them to admit a 10% loss on the value of the property, in return for a cheaper mortgage, many of them would only do it as a last resort, Mr Montgomery says.

We are in new territory now. This is a different game Senate majority leader Harry Reid Ripples spread from Wall Street losses

Some Congressmen suggest that there should be mandatory rather than voluntary restructuring - but that would challenge the complex legal arrangements between the banks and the investors who lent them the money to issue the mortgages.

Another problem that Congress looks ready to tackle is the role of the "mortgage servicers", which, in the new model of mortgage lending, actually collect the overdue payments.

Chairman Barney Frank argues that the complexity of the legal relationships mean that even if banks wants to restructure mortgage payments, the service agencies - which get larger fees for foreclosure than continuing to collect payments - do not.

He wants to look at a major revamp, and further regulation of these service agencies - something that could fundamentally change the nature of the current mortgage system, with its split between those who "originate" mortgages and those who eventually own them after they have been sold off in pieces to other participants in the financial system.

Saving Wall Street from itself

Another idea that is gaining traction in Washington is the creation of a Federal agency to buy up the distressed "toxic" mortgage assets held by the big financial institutions that are crippling their balance sheets.

Such an organisation might be modelled on the Resolution Trust Company (RTC), which was set up in the 1980s during the Savings and Loan banking crisis to buy up distressed local banks which had gone bust after their deregulation went badly wrong.

The RTC took over most of the smaller banks in the US - at a cost of $400bn (over $1 trillion in current dollars) - and then tried to sell off their assets, eventually recovering about half its initial cost.

The cost of such a bail-out would be probably be even higher, with the estimated amount of securitized sub-prime and Alt-A mortgage debt believed to be around $2 trillion - although whether the US subsidies of foreign institutions that hold this debt would be eligible is also not clear.

One issue might be that the US central bank, the Fed, has already agreed to exchange these below-investment grade assets for cash, as it has expanded its lending to the private banking sector through its 'discount window' this week.

No one knows how much this might eventually cost the Fed, but it an unusual move, the Fed this week has already asked the Treasury for an extra $40bn to cover unforeseen costs.

Another problem might be how to treat the $5.5 trillion in mortgage assets owned by Fannie Mae and Freddie Mac, where the Federal government has already seized temporary control of these two institutions.

Political will

But with the bill already mounting for the Federal government, and no end in sight, momentum for Congressional action is growing.

In their hurried briefing with Congressional leaders on Tuesday, the Fed and the US Treasury "made it very clear that they couldn't give us assurances that there were other shoes that wouln't drop," says Senator Kent Conrad, who chairs the Senate Budget Committee.

But there is also a sense that the speed of the meltdown in financial markets is outpacing the existing policy framework.

"We are in new territory now. This is a different game," says Senate majority leader Harry Reid.

With the looming election making early action unlikely, policy makers can only hope that the next phase of the crisis will not begin until the political contests are resolved.