A Non-Prescription for Confronting the Sub-Prime Crisis

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I am so busy doing nothing…that the idea of doing anything—which as you know, always leads to something—cuts into the nothing and then forces me to have to drop everything.

– Jerry Seinfeld

Over 160 American mortgage lenders have gone bankrupt since late 2006. Many observers have blamed a “sub-prime crisis.” Media accounts have portrayed a crisis that will drive millions of American families from their homes.  There is some truth to this: Many Americans face a risk of losing their homes and many have taken out loans they cannot afford. Executives in the home lending business have lost their jobs. This paper attempts to clearly define the problems facing the American mortgage market and outline proposed measures to confront them.

There are several proposals. The Federal Housing Finance Reform Act of 2007 (H.R. 1427) attempts to reform the Federal Housing Administration (FHA). The Expanding American Homeownership Act of 2007 (H.R. 1852) seeks to overhaul the regulations governing Fannie Mae and Freddie Mac. The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648)—almost certain to become law—would provide tax relief for people who have mortgages discharged because of a decline in the home’s value or a foreclosure. And the Mortgage Reform and Anti-Predatory Lending Act (H.R. 3915) would enshrine into law a lending standard called “suitability,” which would impose liability on lenders for making loans that individual borrowers could not afford.

The above proposals are unlikely to provide relief to homeowners in trouble, and may even make things worse. To date, the crisis has been relatively minor—a small decline in homeownership combined with a small uptick in foreclosures, with well-off investors absorbing the bulk of the damage. Doing too much could turn a minor crisis into a major one affecting ordinary Americans.

This paper consists of three sections. The first section describes the sub-prime credit market and the dimensions of the current crisis. The second considers several proposals for reform and describes their flaws. The conclusion makes the case for letting the crisis resolution develop on its own.