In the fall of this year the Bush administration finally realized it was time to act on the unfolding sub prime crisis. After a careful analysis of the economic data available they concluded that the bottom had probably been reached and all that was required was to restore sufficient liquidity in the system as well as some words of reassurance that things would soon be looking up. 'Helicopter Ben' Bernanke lived up to his nickname. Billions of dollars were pumped into the system and interest rates were slashed. President Bush announced that his government would try to ensure that people got to keep their homes, other than speculators and those who had made wrong decisions and overextended themselves. But the housing crisis continued to worsen and the third quarter ended with record foreclosures and mortgage payments behind schedule, and the end was nowhere in sight. It was estimated that the crisis had reduced the economic growth rate by one percentage point. The slowdown was threatening to spread to the other sectors of the economy and maybe cause a recession. The political risks of continuing with a 'laissez faire' approach in an election year were by now unacceptably high. So setting aside its economic convictions, the Bush administration prevailed upon the mortgage industry and the investment firms to sit down with federal government officials to hammer out a rescue plan.
The plan announced earlier this week is a five year freeze of the interest rates on sub prime loans as long as the borrowers are not behind on mortgage payments and continue to live in their homes.Borrowers are also encouraged to avail of refinancing options and move to reasonable fixed rate loans offered by the Federal Housing Authority under its FHASecure program.
The plan invited instant criticism.Some felt that the plan would only help people who made wrong decisions and also those who were in a position to pay. They felt that the correct approach would be to restructure debt on a case to case basis. It was also argued that the plan would benefit only a limited number of people, estimated at about 400,000, and did precious little for the others.Stock market analysts pointed out that the plan would impact earnings of the companies which had invested in this sector and affect their share prices, causing losses to investors.Some pointed out that the modification of existing loan contracts, which the plan would require, was illegal.
These arguments are not very sound. The plan is aimed at a particular subset of borrowers who pose the greatest risk of default. It is quite clear by now that if their problems are ignored then the entire financial system is threatened.This problem has by and large been addressed.Experience tells us that once the entire system is threatened an across the board approach, instead of a case by case approach, works better as it is faster and doesn't cause confusion. Imagine what would happen if millions of loans were to be re-examined and revised agreements were attempted to be worked out in every single case.As far as the mortgage companies are concerned they should be happy because they were in danger of losing even the principal amount they had lent, what to talk of interest thereon.It must be remembered that they had taken a calculated risk while advancing these loans. What is more, they were fully aware of the risks involved, which was reflected in the premium returns they were getting. Suddenly things have gone sour. True, some may have come through better off than under this plan, but it must be remembered that even a giant like Citigroup had to raise additional funds in the Middle East in order to stay afloat. Another wave of foreclosures would not have done anybody any good. Defaults and foreclosures cost a lot of money, and financial institutions are not in the business of repossessing and selling homes on a large scale. Investors are also likely to be better off as financial markets appreciate certainty and are afraid of uncertainty. The certainty of recovering the loans advanced by the mortgage companies is bound to have a positive effect on the share prices of the investment firms involved.
The plan has been largely welcomed by everybody including the Democrats whose only criticism has been that the President has not gone far enough.Sen. Hillary Clinton said that along with home rates , foreclosures should also have been frozen for 90 days. Sen. John Edwards was of the view that loan rates should have been frozen for seven years instead of just five.
The rescue plan is a private sector initiative which helps homeowners at risk of losing their homes. No public funds are involved as yet. The reasoning that lower interest rates would mean lower profits for companies,leading to lower tax payments by them ,and therefore an increased burden on everybody is a bit too far fetched.
Those who advocate a free market and are opposed to any kind of government intervention whatsoever must understand that a crisis as widespread as this one is unlikely to be resolved by people or institutions acting alone, each in his own self interest. Whenever an entire system is at risk government intervention is perhaps both necessary and unavoidable.