The Bush administration's decision to bail out some homeowners with subprime mortgages is bad economic policy, but doing nothing would be worse.
The housing and credit industries are facing a crisis that threatens to cause a recession. While a bailout ends up rewarding home buyers and lenders for poor decisions, an avalanche of foreclosures would harm an even wider swath of the U.S. economy.
President Bush's plan is expected to help 1.2 million home owners with adjustable-rate mortgages stave off foreclosure by freezing their loan rates or refinancing their mortgages.
The proposal targets only a sliver caught up in the credit squeeze. People who can't even afford their initial low mortgage rate won't qualify. Nor will people who bought investment property or a vacation home. The plan is aimed at homeowners making monthly payments now, who will fall behind once higher rates kick in.
Subprime loans are offered to borrowers with poor credit, typically with rates in the first two years of 7 percent to 9 percent. After two years, however, those rates are scheduled to jump to 9 percent to 11 percent. For a mortgage payment of $1,200 per month, that could add $350, forcing many homeowners to default. About 100,000 such loans are scheduled to reset each month for the next two years.
When housing prices are rising, homeowners can avoid higher monthly payments by refinancing their loans. But many borrowers with subprime mortgages are confronted with slumping home prices, and they have little equity in their homes.
Housing prices have leveled off and are dropping in many areas, although the Philadelphia region hasn't been hit as hard yet. Dumping more foreclosed houses onto this weakened market would cause home prices to plummet even further. A higher rate of foreclosures would hurt neighborhoods, undermine consumer confidence and roil financial markets. Consumer spending is responsible for the strong economic growth since 2001.
Washington has been slow to react to the mortgage crisis, even though it wasn't difficult to see it coming. Congress, the Federal Reserve, and Treasury Secretary Henry Paulson all have been taking a wait-and-see approach while the problem deepened rapidly. This plan won't stop a great number of foreclosures, and for other homeowners it might simply postpone judgment day.
But the proposal will help many homeowners, and it could prevent the economic damage from spreading. Those goals are worth taking this step, despite critics who argue that Bush is meddling in a market that will correct itself.
Beyond this short-term aid, however, the mortgage industry needs to get a stronger grip on reality. For too long, certain lenders have been granting home loans without asking too many questions. Income guidelines were winked at. Poor credit was ignored. Some subprime loans don't require escrow to pay taxes and insurance. No wonder so many loans have gone bad.
The Fed - finally - is drafting new regulations to get tougher with monitoring mortgages. Lenders shouldn't shut off credit to responsible borrowers, but there needs to be more protection against consumers getting sucked into deals that sound too good to be true, and are.