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President, Congress and the Fed make belated attempts to repair subprime mess
By Alan J. Ortbals

   As the excesses of the subprime mortgage boom come home to roost, the Bush Administration and Congress are taking action to try to stem the growing tide of foreclosures. Without action by the government, 2008 is expected to be the peak year for foreclosures with more than one million in some stage of the process. Local economists, however, say that this kind of political interference is a mistake.

   Homeowner defaults on mortgage loans are being keyed by large jumps in interest rates on loans made to subprime borrowers. Many of these loans were referred to as hybrid, adjustable-rate mortgages with low, fixed-interest rates for two or three years but then floating with market conditions for the remainder of the term of the loan. Subprime lending has been growing dramatically since 2002 and foreclosures have been shadowing the lending curve. As these "teaser" interest rate periods expire and interest rates are reset substantially higher, foreclosures have been jumping since 2005 and are expected to crest in 2008.

   Large financial institutions like Citibank, JP Morgan and Bear Stearns are experiencing huge losses due to their investments in these subprime mortgages. It is estimated that losses by financial institutions could ultimately reach $220 billion to $450 billion.

   In mid-December, Pres. George W. Bush announced a plan to try to stem the tide of defaults, foreclosures and losses. Referred to as the Paulson Plan after Treasury Sec. Henry Paulson, the idea is to buy borrowers some time by postponing the interest rate resets for five years.

   The plan is voluntary on the part of the participating financial institutions and it's not meant to solve the problems of all troubled borrowers. It essentially separates borrowers into three categories: 1) those who will be able to keep paying after the rates reset or will be able to refinance their loans; 2) those who can pay now but won't be able to when the rates go higher; and 3) those for whom even the current rates are too high. Only the second group will get help, and only if their interest rate resets take place in 2008. Those already impacted are out of luck.

   At about the same time, the U.S. Senate passed legislation to modify the requirements and limitations of guaranteed loans through the Federal Housing Administration. The law would reduce the amount of down payment required for an FHA loan from 3 percent of the purchase price to just 1.5 percent. It would also increase the loan size limit from $362,790 to $417,000. The idea is to make these FHA loans available for people threatened with foreclosure as a result of the subprime mortgage bust so that they will be able to refinance their ARM mortgages. To provide further relief, the Senate also moved to change provisions of the tax code to make restructuring of the mortgage loans more feasible.

   The Senate passed the FHA reform bill by a 93-to-1 margin, but it disagrees with a similar bill passed earlier last year by the U.S. House of Representatives. The House bill would raise the loan limit as high as $829,750 in certain areas of the country. It would also create a new housing trust fund for troubled borrowers and would require the FHA to contribute to it.

   While both plans are meant to try to help troubled homeowners and bring some stability to the mortgage market, Frank Spreng, professor of economics and director of the MBA program at McKendree University, says that the government injecting itself into the process is a mistake.

   "If you let the president interfere with the rates, in the short term those things might all be good, but they have long term impacts," said Spreng. "You can pay a high price for government interference in wages and prices. We know that all the way back to the Nixon price freeze. That was the beginning of a whole series of things that eventually led to that devastating inflation and recessionary period - the so-called 'stagflation period' that we got a few years later."

   Spreng says that, though it may seem brutal, it would be better to let the market correct itself.

   "I think it is very much in the interests of both the borrowers and the lenders to get together and make an arrangement," he said, "but that's a far different thing from the President of the United States or the Federal Reserve Bank or the Congress making administrative rulings or manipulating the market or passing a law that says the buyer and the seller has to get together on these terms. If buyers and sellers get together and work out a mutually acceptable arrangement, that is the market working," Spreng added.

   Rik Hafer, chairman of the department of economics and finance at Southern Illinois University Edwardsville, agrees. He says government intervention will set into motion some bad policy precedents. Although the president's plan only impacts a rather small portion of those affected, Hafer says, the others may decide to sit tight and not take corrective action, hoping the government might bail them out as well.

   "Once the government announces this plan," Hafer said, "will it announce another plan in 2008 in the heat of a presidential election? Will there be more bailouts that come down the road? So, if I were sitting with a subprime mortgage, maybe I would just wait it out and see what happens, too. There will be foreclosures and there will be people who lose their homes. But in a policy sense, how can you cushion that blow without creating a mindset that says the government is always going to bail you out if you make bad decisions?" he added.

   Federal Reserve Board Chairman Ben Bernanke has also laid out proposed changes to try to ensure that the problems that led to the subprime mortgage fiasco are not repeated. These rules include prohibiting lenders from lending without considering a borrower's ability to repay; prohibiting a lender from making a loan without verifying a borrower's income or assets; ensuring that lenders set up separate holding accounts for the payment of property taxes and house insurance; and prohibiting lenders from referring to "fixed-rate" mortgages when the fixed rate is for only a limited period of time.

   If implemented, the plan would apply to all lenders - whether federally or state-licensed - and would result in the Fed taking on considerably more authority for the mortgage market than it has in the past.

   But Spreng is skeptical.

   "The difficulty," he said, "is that the regulations never cover all of the possible things that people might do. Because as soon as you make a regulation, people start to hunt for ways to get around it."