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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.
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"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."
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