Sub-Prime Plan

The Lehmann Letter ©

Sub-Prime Plan

This morning’s New York Times ran a story (http://www.nytimes.com/2007/12/06/washington/06debt.html?_r=1&oref=slogin)
on the Bush administration’s sub-prime-mortgage bailout plan. It contained an observation and a quote that do not inspire confidence.

Any plan must spare borrowers with adjustable-rate mortgages from an imminent reset to a rate higher than the borrowers can afford. The reset is postponed to the day when the borrowers are better able to meet their obligations or home prices rise once again to the point that refinancing become possible. If millions of borrowers are potentially eligible, however, there will be efforts to exclude those who can pay under any circumstances – and therefore don’t need assistance - and those who are unable to pay under any circumstances –and therefore should be excluded from eligibility.

Here is the excerpt from The New York Times article.

“Barclays Capital — extrapolating from a similar program recently unveiled in California — estimates that only about 12 percent of all subprime borrowers, or 240,000 homeowners, would get relief.

“From what I’ve heard, I don’t see anything that leads me to believe we will see an increase in loan modifications,” said Eric Halperin, Washington director of the Center for Responsible Lending, a nonprofit group that has studied the subprime problem.”

Moreover, some have asked the obvious question, “Suppose the housing-price decline lasts longer than anticipated or there’s a recession or there’s a steep increase in interest rates, how will the beneficiaries of the plan deal with a reset any time soon?” Others who are meeting their reset obligations question the fairness of helping those who don’t or won’t meet theirs. And so on.

But there’s a larger issue. Our economic system requires profitability and continually expanding demand. Profits are an incentive to produce and continually expanding demand assures profitability. Accordingly mortgage lenders strive to broaden the scope of their operations. When interest rates reach an irreducible minimum, new methods must be found to expand the pool of potential borrowers. That leads to no money down, no income qualification to borrow and a low (adjustable) teaser rate to draw the borrower into the deal.

The entire economy benefitted from these innovations after the 2001 recession as booming real-estate and home-construction markets pulled the economy out of the trough. The Fed did not object because international competition and plenty of excess capacity held prices down. We had asset inflation rather than price inflation, and asset inflation is not in the Fed’s play book. Then the bubble burst and the flaws became apparent.

Debt is not the lubricant that greases the gears, it’s the fuel that powers the engine. We’ve come to rely on this gas guzzler. There’s no other model in reserve.