The Subprime Mortgage Freeze
Politicians only address symptoms when it's the system we need to fix
December 1, 2008
Fred Foldvary, Ph.D.
Economist

As is typical with government, the U.S. federal government chiefs want to put band-aids on the crumbling real estate market. Governments do nothing to prevent economic turmoil, and then when it happens, they magnanimously treat a few of the effects. And then we are supposed to applaud.

Many borrowers have adjustable-rate mortgages with rates that are scheduled to rise in 2008. This would add to the many defaults and foreclosures that have already taken place. Half a million homeowners may lose their dwellings. The US Mortgage Bankers Association has stated that foreclosures were at a record high in the third quarter of 2007. To reduce the severity of the problem, White House chiefs have asked mortgage lenders to freeze for five years the interest rates paid by sub-prime lower-income borrowers. The plan coordinated by the Treasury Secretary is not mandatory, but it may put pressure on lenders to go along. Behind this prodding is an implied threat of coercion if the bankers don't cooperate.

As of December 2007, the US economy has not yet entered into a recession, but the rate of economic growth has been declining. A declining rate of growth will eventually turn the growth rate to zero and then negative. A large number of foreclosed houses, along with declining average residential real estate prices, is bringing housing construction to a halt, reducing output and employment in real-estate-related industries. Federal chiefs hope that if the lenders freeze the interest rates, there will be fewer defaults, and just maybe the real estate industry will recover.

Ha! The main problem is not the sub-prime mortgages but the collapsing real estate and credit bubbles. The steep rise in real estate prices, led by land speculators, has made housing unaffordable, with even middle-class buyers facing difficulties paying their mortgages. Homeowners and bankers can no longer be bailed out by ever rising property values. So now they look to government to reduce the payments they contracted for.

Economists have pointed out that of course a mortgage freeze is not a free lunch to the economy. Lower payments by borrowers implies less income to lenders. Mortgages have been assembled into packages that were sold to various financial institutions. Defaults have reduced the income from these mortgage packages, and that has led to huge losses by banks, Fannie Mae and Freddie Mac, brokerage firms, and hedge funds. A mortgage freeze will further reduce the income that such firms were counting on, and increase future losses.

Such a change in the mortgage contracts also creates "moral hazard," the tendency of people to take advantage of bailouts. In the future, borrowers may expect to be bailed out, and take on greater loans than if they expect to be personally responsible for the payments. The possibility of future governmental intervention increases the risks of sub-prime loans, and will therefore raise the payment rates, offsetting the effects of the bailouts. This lunch is not free.

Another problem is that only some borrowers would be eligible for mortgage payment reductions or avoidance of increases, while others who have been honestly and diligently paying their mortgages would get no relief.

Banks generally do not wish to foreclose, as this has large costs. Many lenders are willing to work with borrowers to adjust the payments to avoid default. So this government intervention, even if not mandatory, was not really necessary. But it is in the interest of government chiefs to appear to care about people and to be taking action. The headlines declare "Bush freezes sub-prime mortgage rates" even though he did not issue a legally binding decree.

The roots of the real estate problem are the manipulation of the interest rate by the Federal Reserve system and the refusal by governments to tap land values for public revenue. When the Fed expands the money supply to push down interest rates, this induces a real estate boom, as construction takes place that would not be done at the higher natural interest rate. Speculators jump in as real estate prices rise, as the combination of leverage and cheap loan rates make for a tasty speculative treat.

But what really makes real estate prices zoom up is government subsidy. Public works and civic services pump up land values, as these goods are mostly paid from taxes on wages. If landowners had to pay for the works that generate rent and site values, the price of land would be low and steady.

The only way to eliminate the real-estate boom-bust cycle is to switch to free-market banking and to land-based public finance. Private communities such as hotels, condominiums, land trusts, and homeowner associations are efficiently financed from rentals and property assessments. If government did the same, there would be no real estate bubble or mortgage problem.

This band-aid of freezing some mortgages will not prevent the crumbling of the real estate bubble. It is like trying to stop the eruption of a volcano by putting a cap on the top. The lava wants to go out, and it will blow out somewhere. A mortgage freeze does not solve the fundamental problem of excessively high land prices that will choke off investment and cause a recession. The real estate cycle has been going on for 200 years, and nothing short of a shift to land-value taxation will cure it.

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Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.