Earlier this week, James Lockhart, the director of the Federal Housing Finance Agency and the government conservator of Fannie Mae and Freddie Mac, said that the two companies need to begin writing down the principal on mortgages they hold or acquire. This could be an important step in slowing the housing slump. It also suggests that while Fannie and Freddie are largely responsible for the current financial crisis, they might offer a way out.
The Treasury’s use of the Troubled Assets Relief Program (TARP) to recapitalize banks will fail if foreclosures on subprime and other junk mortgages continue to default at their current rates. Bank capital will further decline, eating into the new capital the taxpayers provide. And if foreclosures spread significantly into the prime mortgage market because of the recession, bank solvency will be further undermined.
In other words, to solve the financial crisis, we must address the problem of falling housing values and mortgage defaults. It is imperative to get ahead of this destructive curve.
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