Subprime Policies: New Ideas to Tackle the Mortgage Mess

By Scott Lilly | March 26, 2008

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The precipitous collapse of Bear Stearns Cos., Wall Street’s fifth-largest investment bank and one that had prospered through 85 years of turbulent markets, makes it clear that the current chaos in U.S. credit markets has implications far beyond the million or so families expected to lose their homes in the coming months. It should also provide a clear signal why policies the Bush administration has thus far agreed to put in place do little to address the central challenges presented by the subprime mortgage debacle.

As Federal Reserve Chairman Ben Bernanke explained to bankers several weeks ago, we face not one but two interrelated sets of problems. One is the “toxic waste” of subprime mortgage contracts that now afflict financial institutions around the globe. The other is the collapse of the speculative bubble in U.S. real estate prices that these lending practices helped to create. Finding an effective solution to either of these now intractable problems requires addressing both of them together. Failure to do so could easily lead to a downward economic spiral in which each of these crises continues to feed off of the other.

Bernanke urged the banking industry to utilize “loss-mitigation” arrangements to curb “preventable home foreclosures.” Put simply, he told bankers that it is in their interest to voluntarily write down the principle and interest on mortgages so that financially troubled homeowners can become current on their payments and remain in their homes. As the Fed chairman pointed out, the number of vacant, unsold houses hit an all-time high of two million in December, and the number continues to grow, month after month, in 2008.

Measured in dollars, the value of unsold homes has more than doubled since 2004 and is currently in excess of $1 trillion dollars. Equally disturbing, real estate markets have shown no sign of stabilizing. In just the first month of this year, foreclosure actions were initiated against 153,000 homes nationwide while home sales took only 43,000 houses off the market. More than 700,000 of the 3.6 million subprime adjustable rate mortgages are seriously in arrears and will soon be facing foreclosure. Even worse, many more mortgages are likely to go into arrears in the coming months as interest rates are adjusted upwards.

According to Bernanke, 40 percent of the 3.6 million subprime adjustables are scheduled to reset during 2008. Further, the problem is not limited to adjustable rate loans. Troubled fixed rate subprime loans are growing, and a weakening economy and declining real estate prices are likely to result in higher default rates even among conventional mortgages.

The Fed chief’s assessment is clear: “This situation calls for a vigorous response.” That is true, but a vigorous response requires more than $600 tax rebates spread across the entire U.S. population, and loose credit policies similar to those that helped create these problems in the first place. To date, neither the Federal Reserve nor the Treasury Department has been willing to come forward with a proposal that does more than offer words of encouragement to get those who own distressed mortgages to move rapidly in writing down losses and restructuring loans—the only path to stabilizing real estate and financial markets without serious further deterioration in those markets and the overall economy.

Read the full report (pdf)

To read more on this topic, please see:

• Unbridled Markets: Conservatives Embrace Securitization Run Amok