HOUSING HORRORS

DEMS’ DISASTROUS CRISIS FIXES

By ALAN REYNOLDS

February 26, 2008 -- Barack Obama and Hillary Clinton plan to fix the "subprime mortgage crisis" in ways that would greatly worsen the situation.

In a Financial Times piece last August, Obama wrote that "predatory lenders were driving low-income families into financial ruin.ñ.ñ. The real victims in this crisis are the millions of borrowers .ñ.ñ. whose only crime was taking out mortgages that lenders told them they could afford."

He claimed his Stop Fraud Act would stop "mortgage brokers who are hoodwinking low-income borrowers into taking on loans they cannot afford." More precisely, that bill promises "to stop transactions which operate to promote fraud, risk and underdevelopment."

It certainly would "stop transactions." Under it, even people with no authority to decide who gets what sort of mortgage (such as realtors) could face 35 years in prison and fines up to $5 million for anything deemed deceptive. The predictable effect would be to scare lenders into offering mortgages only to rich people with great credit scores.

Obama imagines foreclosures are confined to low-income families with subprime adjustable-rate mortgages (ARMs). On the contrary, a Mortgage Bankers Association study shows that prime mortgages (mostly fixed rate) accounted for 45 percent of all foreclosures in the third quarter of last year, while subprime ARMs accounted for 43 percent. And even subprime borrowers don't necessarily have a low income or even a low credit rating.

Obama wants untold billions for "a fund to help people refinance their mortgages and provide comprehensive supports to innocent homeowners .ñ.ñ. The fund will be partially paid for by increased penalties on lenders who acted irresponsibly." Sen. Clinton proposed a similar slush fund last December, starting at $5 billion but quickly growing to $30 billion.

This approach is sure to appeal to politicians and bureaucrats - who'd have great fun deciding which homeowners or cities would get financial aid.

Obama admits that "some borrowers were also lying to get mortgages or engaging in irresponsible speculation." Problem is, nobody can easily distinguish liars and speculators from "innocent" homeowners.

Obama also supports a bill to let bankruptcy judges rewrite mortgage agreements at whim. Any deadbeat with a $300,000 mortgage and 7 percent interest rate could ask a judge to make it a $200,000 mortgage at 5 percent. If the bill passes, expect a runaway stampede into bankruptcy courts as to take advantage of this opportunity.

The key flaw? Anything that increases the risk of loan losses inevitably increases interest rates. That's why junk bonds pay a higher rate than Treasury bonds. If we let mortgages be rewritten by judicial caprice, we're converting mortgages into junk - and so greatly increasing mortgage rates.

Hillary Clinton has a more heavy-handed approach. She wants a 90-day moratorium on subprime foreclosures. After giving its select beneficiaries an extra three months of rent-free living, this move would drop a huge backlog of foreclosed homes on the market at once - with a nasty crashing sound.

She also wants to dictate an "automatic freeze" for interest rates on subprime ARMs - keeping rates at the below-market introductory rates for "at least 5 years, or until subprime mortgages have been converted into affordable loans."

That has to be unconstitutional - the government can't blithely rewrite the terms of two private parties' contract. But it's also a terrible solution to the wrong problem.

Again, nearly half of foreclosures have been on prime mortgages - triggered by falling home prices, not by rising interest rates. Even for subprime ARMs, the interest rate re-sets after a couple of years based on the 1-year LIBOR (an interest rate on loans between banks). That rate has dropped to 2.8 percent - which means the increased monthly payment on subprime ARMS will be less than 10 percent, not the 30 percent she claims.

In other words, it won't be as big a deal as Clinton thinks when subprime-loan rates adjust. The real danger is if house prices drop below the size of the loan - because many people will then walk away from the mortgage, regardless of the interest rate.

If Congress acts to arbitrarily freeze mortgage interest rates, as Clinton wants, lenders will start guarding themselves against the chance that lawmakers might do the same thing again someday. That is, they'll see mortgages as highly risky investments - so future would-be borrowers will find mortgages scarce and expensive.

Obama gets it. He warns, "A blanket freeze like she's proposed will drive rates through the roof on people who are trying to get new mortgages to buy or refinance a home."

Quite right - yet his proposal to let judges reduce rates and the size of loans would drive rates through the roof for exactly the same reason.

Obama's main concern is that it's been much too easy for low-income families to get home mortgages. He plans to put a stop to that by 1) threatening lenders with fines and prison and 2) letting judges tear up the contracts and write new ones.

Ironically, one reason we got into the current mess is that Washington spent the last few decades criticizing and fining mortgage lenders for not lending to low-income households with imperfect credit records - a practice called redlining. Now Obama plans to punish lenders in criminal and bankruptcy courts until they bring redlining back.

With friends like Clinton and Obama, prospective low-income homeowners won't need any enemies.

Alan Reynolds, a senior fellow with the Cato Institute, is the author of "Income and Wealth."