Mortgage Bailout Could Make Crisis Worse

The property of millions of “homeowners” is now at risk due to the mortgage meltdown. As interest rates reset, not just subprime borrowers but millions of prime-rate borrowers are now facing imminent foreclosure.

According to CBS News (12-6-07) in the first quarter of 2007 alone, some 994,000 homes were foreclosed. Horror stories of monthly payments going from $1,000 a month to $2,000 in a heartbeat, are now reported by newspapers across the country. And it’s getting worse:

Some 2.5 million borrowers are now behind on their mortgages, and millions more will likely slip into arrears in the coming year. Also at risk are banks, insurance companies, and thousands of independent
lenders. Moody’s Economy.com now reports that “Housing markets from Punta Gorda, Florida, to Stockton, California, will crash and suffer price drops of more than 30% before the housing crisis is over.

And the financial damage isn’t confined to the U.S. Millions of U.S. home loans have been bundled together and sold to banks across the planet as CDOs — collateralized debt obligations. As a result, if the mortgage meltdown continues, we could see many bank and business failures . . . hundreds of thousands of families out on the streets . . . and a major recession in 2008.

In the wake of all of this calamitous news, it isn’t surprising that the government has taken action. Specifically, President Bush has called for a “voluntary” 5-year freeze on low introductory mortgage rates for families now making payments but unable to afford higher rates. Only primary home owners would qualify, and they must have a perfect record of home payments.

Once such a measure is introduced, it would likely expand. Indeed, others, are already proposing a permanent, mandatory freeze in rates. While the desire to “do something,” about the mortgage crisis is natural, a mortgage rate freeze is unlikely to do more than prolong the grief and could well turn what would have been a short recession into a protracted depression.

You see, the fundamental problem isn’t that so many families are facing default and foreclosure. The problem is that many of these families simply do not have income sufficient to make house payments and shouldn’t have borrowed the money in the first place. Consequently, freezing rates could well create even worse problems a few years from now, because freezing payments for people who aren’t even able to afford interest (much less interest plus principal) means their total debt will continue to increase while rates are frozen, resulting in them being hit by even higher payments a few years from now, and an even worse crisis.

There is also the legal problem of the government unilaterally rewriting mortgage contracts for millions of borrowers. What lender in their right mind would loan funds when the government can force them to take “payments” that don’t even cover their costs, and blocks them from repossessing their property when borrowers default? If banks, insurance companies and other lenders stop making loans, the mortgage crisis will get far worse. Any freeze of interest rates also inevitably means huge losses and failures by banks and other lenders which were counting on higher, reset interest rates to make a profit on their loans, after a few years of loss-leader low teaser rates.

There is also the sticky question of how Chinese, Japanese, and European banks will react when they told they can’t collect increased payments that they were anticipating. Loss of their investments would be economically disastrous for our economy. For all of these reasons, freezing interest rates and mortgage payments for subprime borrowers could well be a cure much worse than the disease.
Certainly living through a 2008 recession would be painful, and no one wants to see lots of families lose
their homes.

But that would certainly be far less painful that creating an international depression that lasts for many years and harms billions. As documented in the late Murray Rothbard’s brilliant book America’s Great Depression, that is precisely what happened in 1929, when government “help” turned what should have been a 6-month recession into a 10-year long depression. Let’s hope history doesn’t repeat itself today.