Why the Rate Freeze Won't Warm the Economy

If the aim is to avert recession, Bush's mortgage plan won't work, an economist says.

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It will bail out some drowning homeowners, but don't expect the Bush administration's subprime survival plan to do much for the broader economy. The "voluntary" deal with lenders will freeze the interest rates on several hundred thousand subprime mortgages, helping many homeowners avoid foreclosure. That's good, except that a few niggling details are still unsettled—like who will pay for the losses that the rate freeze will cause lenders. Nor is it clear how the plan will aid economic growth, or what other consequences—including unintended ones—there might be. I asked James Barth, an economist with the nonprofit Milken Institute in Los Angeles, to help explain the likely impact of the deal:

The purpose of this agreement, supposedly, is to avert a growing problem that could threaten the overall economy. Is there some way to tell whether it will do that?


Let's start with the numbers. Just short of 2 million people are subject to interest-rate resets. About one third of them may benefit from this so-called voluntary agreement between the government and the lenders, another one third won't benefit at all, and another one third will be in foreclosure, so they won't benefit either. So that's about 600,000 people who will be affected. That's not a lot. The government insists this isn't a bailout, and it's not going to be funded by taxpayer money. So who's going to pay for it?


If this was good for lenders and borrowers and investors, then they would have done this without any push from the government. If it was a win-win, they would have done it on their own. So you're right, we should assume that means somebody will pay a price. Who?


Investors. Who are the investors? Individuals or big institutions?


Institutional investors from all over the world. Pension funds, hedge funds, big banks, foreign governments. And the question is: Will they go along? Can the servicers of these loans alter the terms of a loan without the investors' agreement? In other words, the investors are people or groups who bought securities backed by these loans, which have certain characteristics. And now those characteristics might change... .


That's right. In cases where these are hybrid loans with an introductory teaser rate that goes up, what the big investors bought is a security not backed by a fixed rate but by a value that is liable to adjust upward. So investors may go to court and say, "Hold on just a second, we don't agree with this." So the cost of the agreement will mostly be borne by those investors?


Yes. But look at what happens in the insurance industry when there's a natural disaster: They pay a lot in claims, but subsequently premiums go up to cover the cost of those claims. We could see the same thing here, except that it would be interest rates paid to investors going up. Investors would demand a higher interest rate because they'd say, "Well, gee, if this happened once, it could happen again." That in turn would lead to higher mortgage rates. Essentially, that would be a large group of people bearing the cost of something that's now being borne by a much smaller group of people. It's almost like a transfer payment, isn't it?


It's a cross-subsidization. Other people are subsidizing the losses of a few. Instead of concentrating the losses on the people who incurred them, we'd be spreading them across a much larger group. Is that a logical solution, economically?


Well, it's not equitably fair, because somebody who's going for a new loan isn't responsible for the subprime problem. But the effects would likely be small. When you have a large base of loans, you don't have to raise rates by much to cover the losses. Is there any way to tell yet what kind of effect all of this might have on the economy? Whether it would be significant, marginal, negligible?


The effects are likely to be marginal. The number of potential borrowers is pretty small. I'm not sure there's any effect from this that would significantly help prevent a recession. Why not?


Usually when housing prices go down, you get what's called a wealth effect: People's wealth is lower, they basically spend less, and since consumer spending accounts for two thirds of the economy, economic activity slows down. Along with that, you might also get some increase in unemployment, and some incomes would go down. Now even if you avert some of these foreclosures, it won't stop wealth and incomes from going down. You might keep some people in their homes, but if housing prices are dropping, their house is still worth less. You'd still have the wealth effect. So I don't see any numbers that make me think freezing the teaser rates on 600,000 mortgages will significantly help avert a recession. Freezing interest rates, as this plan calls for—isn't that a kind of price fixing?


It certainly smacks of price freezes, of [the 1970s'] Whip Inflation Now program. "Let's whip the subprime mortgage problem now." Have price freezes ever worked before in a free market?


Not really, but let's remember, there's a political campaign taking place. And where are some of the states with significant subprime problems? Ohio, California, Florida. Are those important states in the election? There's another issue we should think about. What if this works? Four or five years from now, will we have a new policy tool? Will we have monetary policy, fiscal policy, and now, housing policy? If there's some kind of stagnation in the housing market, could the government just say, "Let's freeze rates? Or better yet, let's lower them?" These are the types of questions we should ask in a serious way.

Bailing out some of the people who took out these risky loans—does that amount to rewarding reckless behavior?


I wouldn't go that far. There's always a group that may have been misled or not understood the products they were getting, and there's a subset of individuals we should be concerned about. But there were others who gambled on these loans with a low teaser rate because they thought the value of housing would keep going up, and they'd be able to refinance and get a fixed-rate loan based on greater collateral in the house. If you're going to make important decisions based on expectations that you'll have favorable future performance forever, you're an extreme optimist. This seems elementary, but aren't the lessons here pretty basic ones, like don't spend beyond your means? And read the fine print. You know, caveat emptor?


Exactly, but remember that there were a lot of people who took out subprime loans and aren't having a problem. It's really the people who took out the loans just as prices started to decline and are now finding they can't refinance at a fixed rate because their home is suddenly worth less and they have no equity. That's why the rate freeze only applies to people who took out loans from 2005 to 2007. The people who got in earlier, they're mostly OK. But a lot of people said, "There's a housing boom going on, and I'm missing out. I want to get in on it." But by the time they got in, it was over. Obviously, booms don't continue forever.

TAGS:
economy
subprime mortgages
interest rates
  • Rick Newman

    Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success and the co-author of two other books. Follow him on Twitter or e-mail him at rnewman@usnews.com.

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