Building a firewall

As the financial crisis in the United States deepens, we in Canada soon will feel its effects. Nearly half of our gross domestic product is derived from exports to that nation. There, demand inevitably will contract; we undoubtedly will be caught up in that mess.

New techniques have been developed over the past several decades, in order to minimize the debt crisis now besetting our financial markets. They were not in existence until a few years ago, long after this columnist was attending university and graduate school. They are complex and fail to counteract the debt problem. In fact, they tend to obscure it, but fail to cure it.

For instance, collaterized debt obligations have appeared on the scene. There, small amounts of debt, such as individual mortgages, are combined into little sections and sold as bonds. Inasmuch as the ownership of these bonds is diffuse, no one can know who holds what mortgages and, therefore, cannot adjust them in any way. This is a far cry from previous eras when a local bank manager knew the prospective house owner and could work out a sensible, affordable mortgage.

Now there are credit default swaps. These holders of mortgage-backed bonds or standard bonds are shifted to some other lender. The obligations are conveyed to another institution before maturity for, perhaps, 75 per cent of their face value. The original lender is paid the 75 per cent of the obligation, and the buyer of that credit could collect the entire amount of the debt, or in case of default, receive nothing. Those so-called credit default swaps clearly are fraught with risks to the ultimate holder of the debt, something happening now.

To complicate the above, derivatives have become commonplace. Derivatives are, say, an option whose face value is dependent on the value of the underlying asset. Financial institutions are trading derivatives in astronomic numbers. One major Canadian bank literally has trillions of dollars in derivatives outstanding.

Given the above, it should be no surprise that we have complicated, risky debt and financial troubles. The U.S. $700-billion bailout package does nothing to address these problems, which currently are compounded by the housing crisis. Too many have purchased houses with insufficient resources and have found themselves unable to meet mortgage payments. Mortgage defaults and foreclosures have followed, jeopardizing our economic structure. We must build some kind of firewall to prevent the housing industry’s difficulties from infecting the entire economy.

There are no easy solutions to the housing crisis. If at all possible, the federal government could establish a "bank" to take over existing mortgages and charge reduced interest rates.  Martin Feldstein, a Harvard economics professor, has suggested issuing mortgages with lower interest rates, but with full recourse. That is all the holder’s assets could be seized to pay the mortgage.

Somehow, we must devise a program to tackle the housing crisis, something that the U.S. has failed to design as of this date.


Bruce Whitestone