What Good Will A Market Stability Regulator Do?

Question: You have written that the government's proposed regulatory response to the subprime lending scandal is overkill. How so?

Saletta: My primary concern is with Paulson's plan to name the Federal Reserve the "Market Stability Regulator." If there is any lesson to be learned from the subprime fiasco, it's that risk cannot be eliminated, just transferred. Any time you falsely appear to drive risk out of a market, you actively encourage larger and more reckless risks.

If it weren't for the bundling and derivatives that appeared to reduce the risks of owning subprime mortgages, how many of those now failing mortgages would have originated in the first place? Imagine what happens if you take the larger risks enabled by those innovations and multiply their destructive power by backing them with the full faith and credit of the United States Federal Reserve. The chaos from the next round of excess leverage in that world will make this seem like a walk in the park by comparison.

Question: if some regulation is appropriate, what would that regulation look like?

Saletta: I would like to see a law that lets people deduct a capital loss on the sale of their home. Right now, if you sell your house for less than you paid on it, it's a nondeductible personal loss. Allowing a deduction would at least help cushion the blow for folks who are forced to sell their homes for less than they paid.

Also, I think it would be a good idea to undo the recent law that made it harder for people to discharge their credit card debts in bankruptcy. It used to be that people would neglect their credit cards to pay their mortgage and keep their homes. Now, it seems like it's easier to walk away from a house and mortgage than a credit card. Walking away like that drags down property values for whole neighborhoods, whereas a personal bankruptcy is an individual problem rather than a community-wide one.

Question: Correct me if I misunderstood, but I think the point of your recent column was that the market itself will correct the problem if given the chance. How?

Saletta: Through the same mechanism via which the market always works - price. The reason homes aren't selling is because people aren't willing to pay and banks aren't willing to finance the prices that houses fetched a year or two ago. Let the market find its bottom, and houses will sell and banks will write mortgages again.

If you're forced to move, what's more painful? Selling a house for $300,000 that you paid $350,000 to buy, or listing the house for $350,000, watching it sit, and potentially being forced to pay two mortgages or a mortgage plus rent for a year or more while nobody takes your old place?

The sooner we get out of this mess, the better it is for all of us. For us to even think of climbing back out of this hole, the housing market needs to find its bottom. The longer we delay finding that bottom, the longer the credit and housing markets will stay seized up, the longer the overall economy will stagnate, and the worse the end result will be.

Question: In the meantime, how if at all would you address the needs of individuals victimized as a result of the crisis?

Saletta: The true victims of this crisis are the people who played by the rules, saved up a down payment, and took out a traditional mortgage that they could afford. They're the ones staring at outrageously inflated property tax bills that are based on bubble-level appraisals. They're the ones who could have "kept their powder dry," invested their down payments elsewhere, and had a stronger cash/investment cushion outside of their homes with which to weather this storm.

And most importantly, they're the ones whose life savings are being destroyed by the Federal Reserve's misguided rescue attempts. The Fed's aggressive rate cuts are both fueling inflation and destroying the value of and returns on hard earned, scrimped and saved cash. Rather than "saving" the economy and the housing market, the Fed's inflationary policies are making it all that much tougher for those who played by the rules to make ends meet.

Even worse, with so much formerly disposable income being eaten up by the gas tank or dinner table thanks to the Fed's inflation, the rest of the economy is at bigger risk than it was before. If you're barely making ends meet, if you don't absolutely need something, you don't buy it. That causes a second round of problems and serious cutbacks for anyone and any company in any industry that's not strictly necessary.

Help to the real victims of this catastrophe looks like higher interest rates and a stronger dollar to quell inflation and a housing market that's allowed to sink back to rational levels of affordability. Then and only then will the real victims of this catastrophe get the relief they so desperately need and deserve.

Read more on the market stability regulator in Lora's article "Contemplating a More Powerful Fed" http://www.itbusinessedge.com