THE ECONOMIC crisis now unfolding is not like other postwar recessions, which could be fixed with low interest rates and deficit spending. This crisis reflects the collapse of major parts of the financial sector.
That's why the Federal Reserve convened a rare emergency meeting Monday and slashed short-term rates by three-quarters of a point, to 3.5 percent. But the structural damage to the financial economy can't easily be fixed with low interest rates.
Subprime mortgages, lent on extortionate terms to shaky borrowers, spawned layers of exotic bonds. Normally, when a bond loses value, markets just trade the bond at a discount. But in this case, the collapse of the subprime sector is so severe that many bonds are not trading at any price.
Banks have now lost tens of billions of dollars of capital, reducing their ability to lend, adding to the general credit contraction, and worse is yet to come.
Instead of debating the finer points of a "stimulus" package, or the Fed's next rate cut, Congress and the White House should get together to rescue the housing sector. Home equity represents the greatest part of the net worth of the American middle class.
At present rates of decline in housing values, homeowners will lose more than $2 trillion in home equity this year alone. That loss will deepen the recession, because consumers will spend less money on durable goods, home improvements, and other purchases.
Millions of borrowers face foreclosures because, knowingly or otherwise, they took out bait-and-switch subprime mortgages, often with no down payments. With housing values depressed, many loans now exceed the value of the house.
In the old days, before mortgage loans were packaged into bonds, a distressed borrower and a lender could negotiate a lower rate. If the bank just foreclosed, the borrower would lose the house and the bank would be stuck with a property worth less than the mortgage. By lowering the interest rate, the bank would take a smaller loss, and the borrower would keep the house.
Today, however, the bank seldom holds the loan - because the geniuses who thought up subprime packaged the loans into bonds. Renegotiating terms of these bonds is like unscrambling an egg.
What's needed is a government body like the Home Owners Loan Corporation of the New Deal era, when America last faced mass mortgage foreclosures. The HOLC issued tax-exempt bonds, and used the proceeds to refinance distressed mortgages at low rates.
According to Alfred DelliBovi, president of the Federal Home Loan Bank of New York, writing in "The American Banker," by 1935 the HOLC had refinanced 20 percent of all qualifying US mortgages. It saved close to 1 million Americans from foreclosure.
Today the problem is trickier, because so many mortgages have been packaged into bonds. But a new HOLC could buy back the bonds, at a steep discount, from large financial institutions that can't find anyone else to purchase them. Most bondholders would gladly take the deal.
The HOLC could then offer low-rate mortgages. With these discounted mortgages, homeowners who couldn't afford the exorbitant terms of their subprime loans could keep their homes. Other vacant homes could be reoccupied by new homebuyers. This process would brake the steep decline in housing prices that is dragging down the rest of the economy.
"You need a central place for the homeowners and the bondholders to go," DelliBovi told me. He was once a sub-Cabinet official under George H.W. Bush. "I'm not a big government guy," he added. "I'm a conservative Republican. But sometimes the only solution to a serious crisis is a government institution."
Politically, this approach has the support of many housing experts but few politicians. Republicans are wary of a new government agency. Democrats are skittish about anything that smacks of a bailout. But they should think again.
In fact, the bondholders, not the taxpayers, would be absorbing the loss. (The original HOLC returned a small profit to the Treasury.) Getting these markets flowing again would prevent far greater losses to homeowners and the general economy. And allowing investors to realize some value on the bonds will prevent bigger bailouts down the road.
The eventual bipartisan "stimulus" package may well be too puny to promote a robust recovery. But a major refinancing of distressed housing is one bipartisan grand bargain worth making.
Robert Kuttner is co-editor of The American Prospect. His new book is "The Squandering of America."