Perhaps wanting to preempt Congress before it returns next Tuesday, President Bush offered his own plan to deal with troubles in the housing market.
The plan wisely avoided a paternalistic “suitability” standard such as that proposed by Sen. Chuck Schumer (D-N.Y.), which would treat borrowers almost like children and make lenders virtually guarantee that loans could be afforded. As I have noted, such an approach would make lenders overcautious and deny loans to anyone who had a slight blemish on his credit record. This approach would result in reduced opportunities for families to better their economic circumstances and would also worsen housing woes by making the market less liquid for buyers and sellers, due to the reduction of financing vehicles.
Nevertheless, the President’s plan contains elements that could be problematic. The Federal Housing Administration bailout of troubled mortgages, while limited, could distort the housing market and prevent more effective refinancing plans. And if his planned crackdown on lenders is limited to those who engaged in fraud, that is good. But the broad brush he used in tarring adjustable rate mortgages could send a signal for heavy-handed regulation by federal agencies, which would raise costs and weaken the housing market further.
Before I rate the elements of Bush’s plan, let me try to put the “crisis” in perspective. I don’t claim to be an all-knowing expert about the credit crunch, but there are some important facts that have been overlooked in many accounts.
One is that the jury is still out on how connected subprime mortgages, or even home mortgages in general, are to the stalling of credit in the corporate sector. Washington Post economics columnist Robert J. Samuelson has argued, “Although subprime U.S. mortgages — home loans to weak borrowers — are the center of attention, they’re not the real problem.” One factor in the corporate credit crisis may be that entrepreneurs used the debt market much more than in the past to raise growth capital, because laws like Sarbanes-Oxley made it so costly to raise money through the public equity markets. Watch for a forthcoming analysis I have on this theme.
In any event, it’s important to remember that the overall foreclosure rate is still only around 1 percent, and even for subprimes, about 15 percent. This is not to minimize the hardships for those who are having troubles with their mortgages, but to remind of the forgotten individuals who benefitted from the innovations in lending. Because of things like adjustable-rate mortgages, home equity loans, and new types of refinancing, more people at all income levels were able to become homeowners, and wise borrowers were able to use these loans to fulfill financial goals such as sending their kids to college (Money magazine recently noted that home equity loan rates were lower than even many subsidized federal college loans) and freeing up cash to start a small business. The forgotten majority should not be punished by unwise government intervention that would limit their opportunities.
That said, based on the outline of Bush’s plan, which could be different from what is actually carried out, here is the good, the bad, and the neutral.
The Good: Tax Forgiveness
Bush is right to stop the IRS from adding further burdens to troubled borrowers. There is broad bipartisan support for stopping the agency from treating the refinancing of a loan at lower rates as “loan forgiveness” that should be subject to the income tax. It’s unclear if this refinancing would actually be “loan forgiveness,” since a borrower may pay less in a given year but more over the duration of the loan. The real fix for this problem would be tax reform, but until then, this temporary fix would provide needed and appropriate relief. I’m also seldom one to turn down a tax cut in any form, since Americans are already so burdened with taxes.
The Neutral (or Good and Bad at the same time)
As said before, using existing law, to crack down on lenders who engaged in fraud is a good thing, and one the federal agencies had been doing long before the President’s speech. If the speech makes it priority, so much the better. The problematic aspect is that Bush seemed to tie that together with “tightening” lending standards and painting innovations like adjustable-rate mortgages with a broad brush. If regulators were to take this as a license to ban or crack down on certain types of loans, with no underlying fraud, this would limit options for homebuyers and sellers.
There is nothing wrong with adjustable-rate mortgages per se. They have been the main type of home loan in Great Britain for decades. The Mortgage Book, a home buyer guide published in 1992 by Consumer Reports, whose parent Consumers’ Union is now a critic of many of these types of loans, stated that “adjustable-rate loans do have a few genuine advantages” for borrowers. Among these, the book notes, are lower initial interest rates than fixed rates, and an easier ability to sell a home, because a lender would be more likely to let a new party assume an adjustable loan in the face of rising rates. So the upshot of ARMs being outlawed or curtailed would be a less liquid housing market that would disadvantage many buyers and sellers.
The Bad — FHA bailout
The details are vague on the Federal Housing Administration (FHA) bailout, and it appears to be limited. Yet the basic outline itself is a bad concept. There already is a market for refinancing for buyers and sellers in an open market. Advertisements for refinancing loans and changing ARMs to fixed-rate loans run on TV all the time. So FHA-subsidized refinancing would at the very least distort this market and at worst crowd out private lenders who would keep the housing market moving. None of this would be a good outcome for the economy overall.
Contrary to impressions in movies, banks do not want to foreclose on a loan, for the simple reason that they most often lose money on foreclosures. In fact, according to a 2003 Federal Reserve study, banks can lose 30 to 60 percent of the outstanding loan balance because of legal fees and property expenses associated with foreclosure. This gives borrowers some real bargaining power in negotiating a refinancing deal with their lenders. Instead of bashing a class of loan or lender, housing advocates would be better served educating troubled homeowners on how to use this bargaining power.
Have a great Labor Day!