THE LARGER SUBPRIME CHALLENGE
By David M. Walker
March 31, 2008
The very disturbing parallels between the factors contributing to the current subprime mortgage crisis and our nation's growing fiscal challenge should serve as a wake-up call to Congress, the Bush administration and the presidential candidates regarding the need to take tough but necessary steps to avoid much greater economic disruption in the future for tens of millions of Americans.
In the meantime, Americans would be best served if policymakers addressed both the current consumer and looming federal mortgage threats at the same time.
The current mortgage disruption evolved from homebuyers speculating that real estate prices would continue to rise and interest rates would stay low. Too many mortgage loan transactions were based on the assumed value of a home rather than the creditworthiness of the borrower. As a result, many of the loans that were made did not pass the "straight-face test" of a considered evaluation of the ability of the borrower to pay and the related credit risks.
There was also a basic disconnect between the parties that originated the mortgage loans and earned the related fees and those parties who ultimately bore the related risk of default. This situation was exacerbated by a lack of transparency associated with a number of the more creative and risky mortgage-backed security arrangements.
The result has been serious adverse implications for certain financial services firms, many investors--including those who had a significant asset allocation to financial services firms--and millions of homeowners, especially those who are facing foreclosure.
Bear Stearns found out the hard way that, irrespective of the book value of the firm, cash flow is key, and when investors lose confidence in a firm where "trust" is a key element of its business, things can reach crisis proportions and spiral downward very quickly.
And as the markets continue to roller coaster, investors continue to lose money and American homeowners face possible foreclosure, what should the government do to stop the hemorrhaging?
The simple answer is to do what it can to avoid a downward spiral of foreclosures with all the related consequences. At the same time, the government should not "bail out" financial firms or individuals who made risky investments or engaged in inappropriate practices.
There is, however, a larger problem in Washington that the next administration and the next Congress must address. Specifically, the current federal fiscal policy has created a disconnect between today's citizens and future taxpayers. Baby boomers and current retirees benefit from today's government spending and tax policies, while our children, grandchildren and generations to come will be expected to pay the bill for today's excess consumption.
From a broad perspective, many in Congress think that since the U.S. is currently the world's sole superpower, we will always be able to borrow from foreign countries whenever necessary at attractive interest rates. Unfortunately, the government--like too many Americans--has become addicted to debt.
With a federal deficit in the billions, government appears numb to running large operating budgets every year, irrespective of the state of the economy or the existence of wars. The resulting deficits and related debt burdens are set to escalate dramatically when baby boomers retire in big numbers.
To put things in perspective: Absent meaningful reforms, income tax rates would have to more than double from today's levels for the federal government to deliver on its promises and pay its bills.
Washington's current imprudent and immoral behavior is facilitated by a lack of adequate transparency associated with the federal government's unfunded promises for Social Security, Medicare and other programs. In fact, Social Security and Medicare alone are already underfunded by about $44 trillion, or $146,000 per American, in today's dollars, and this number is growing on autopilot every year by about $2 trillion, or $6,600 per American.
The related funding shortfall has already resulted in a negative cash flow in Medicare's hospital insurance program. In addition, the combined Social Security program is projected to begin experiencing a negative cash flow within 10 years. What needs to be done?
First, we need some candor and leadership from our next president and from a few capable and caring members of Congress on both sides of the aisle. We also need to reimpose tough budget controls, constrain federal spending, decide which of President Bush's tax cuts will stay and which will go, and then engage in comprehensive reform of our entitlement programs, health care and tax systems. The sooner, the better, because time is working against us.
And although organizations like the Peter G. Peterson Foundation will do their best to ensure that policymakers act to address these large, known and growing fiscal challenges, all Americans should make sure Washington knows the time has come for results rather than rhetoric. If policymakers fail to act, many Americans will eventually face far more serious economic hardship in the future when our foreign lenders lose patience with Washington's ways.
David M. Walker is president and CEO of the Peter G. Peterson Foundation and former comptroller general of the United States.
