Making the Mortgage Mess Worse

Recently the Bush administration unveiled a plan for homeowners facing foreclosure to receive a 30-day reprieve from their creditors. This might come as welcome news in Sacramento where a jaw-dropping 46 percent of December sales were foreclosed homes. Unfortunately, the latest plan-as well as earlier government ideas to freeze rate resets on adjustable rate mortgages-will only exacerbate the mortgage and housing crisis.

California enjoyed one of the hottest real estate markets during the boom, but that left is poised for a big fall. According to the latest S&P/Case-Shiller Home Price Index, the L.A. market has suffered a 15% drop from its peak in September of 2006, one of the worst declines in the country. Yet before coming up with possible solutions to this mess, we need to understand exactly what went wrong. The fundamental problem was that lenders granted mortgages to borrowers who did not have the ability to service those loans, unless housing prices continued their rapid ascent. When the housing bubble burst, it became immediately clear to borrowers and lenders alike that millions of homeowners were in over their heads.

This realization cast into doubt the worth of financial assets constructed from bundles of such mortgages. No one has explained how relieving borrowers from their contractual obligations is supposed to alleviate the strain on financial markets. After all, if a lender is worried that the borrower will be unable to make his monthly payments, it is little reassurance to change the terms of the agreement in favor of the borrower.

Delaying foreclosure by a month, or freezing mortgage payments on ARMs, might be compassionate, but it won’t change the fact that financial institutions need to write down hundreds of billions in lost asset values. In fact, the constantly evolving pleas for various forms of government relief will only make the credit crunch worse, because banks and other holders of mortgage-backed securities have the incentive to postpone a full disclosure of their true financial position. Why tell your investors exactly how many billions you lost, when it’s possible that next month Uncle Sam will announce a bailout?

The Federal Reserve itself bears much of the blame for our current mess.

In an effort to stave off recession, Alan Greenspan slashed the federal funds target from 6.5 percent in January, 2001, to an incredible 1.0 percent in June, 2003, where it stayed for a year. Then the Fed systematically hiked the target from 1.0 percent in June, 2004, back up to 5.25 percent in June 2006. Given the close relationship between interest rates, mortgage payments, and housing prices, it seems obvious that Fed policy played a large role in the housing boom and bust.

Where does that leave us now? Unfortunately, there is no quick and easy fix, because the damage has already been done. Misled by the upswing in home values, many owners refinanced and used their equity to buy fancy meals, SUVs, and plasma screen televisions. The physical resources used to produce these consumption goods are now gone, and nothing the government does can bring them back.

By the same token, speculators looking to “flip” second homes for a quick profit contributed to the housing boom, and directed resources into home construction that otherwise would have gone into building more factories or tools. Those mistaken decisions are largely irrevocable-it would be silly in most cases to knock down a house for its scrap material-and our economy is that much poorer now because of them.

The housing boom misdirected scarce resources. Workers ended up making too many consumer goods and too many houses. The only recourse is to slog through with the always effective ethic of hard work and frugality.

Just as individuals need to recover from this episode by restricting consumption and replenishing their assets, so too must the economy as a whole. There are no magic cures because bricks and mortar don’t grow on trees.

The government definitely has a role to play. By cutting marginal tax rates, it can provide extra incentive for people to produce those resources consumed during the boom. But beyond general measures such as these, the government needs to get out of the way. In particular, the Fed should be wary of excessive rate cuts designed to minimize the pain of the present downturn. After all, it was massive cuts-all with the aim of helping, of course-that got us into this mess today.

Robert P. Murphy, Ph.D. is a Senior Fellow in Business and Economic Studies at the California-based Pacific Research Institute. He is the author of The Politically Incorrect Guide to Capitalism (Regnery 2007).

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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