Monday, January 28, 2008

Economic Effects of Freezing Subprime Mortgage Rates

Readers Question: Bush proposal to freeze down rates on subprime, will this have any impact in the future regarding our economy and is it going to have political consequences?

The problem with subprime mortgages is that many homeowners are coming to the end of their 'introductory period' In this introductory period, the mortgage interest rate is very low (the incentive to buy the mortgage) However, when the introductory period ends, it means they move to a much higher interest payment. It is feared that upto 500,000 homeowners could be at risk of defaulting leading to home repossession. This would have serious economic consequences.
  1. Decline in Consumer Spending. People who face higher mortgage payment will spend less, causing a fall in economic growth. With the economy close to recession, this could be a decisive factor.
  2. Losses for Mortgage Companies. If homeowners default on mortgages, banks will lose more money related to subprime. True, they can repossess the house, but with falling house prices this is little comfort.
  3. Financial losses. It is not just mortgage companies who will lose out on mortgage defaults, many high street banks have bought 'subprime' debt so they will also be affected. This will lead to a tightening of credit for the average consumer
  4. Falls in House Prices. If more homeowners do default on their mortgage payments it will cause further falls in house prices. (People will be selling not buying). Falling house prices will definitely reduce US consumer confidence and US consumer spending making a recession more likely.
The plan to freeze subprime interest rates for 5 years, could be a way to avoid some of these effects. From what I understand, the plan is voluntary and banks have no compulsion to join the scheme. However, it may be in their best interests to join, rather than suffer more repossession and loan defaults.

Moral Hazard.

There is an argument that this plan encourages irresponsible lending. Banks have made a mistake in lending so much mortgages, if they can avoid the consequences it may encourage them to do the same.

Political Effects.

I think the plan has some merit, it doesn't use taxpayers money, because it is a voluntary scheme. It is really the mortgage industry acting in its own interests.

Note: the recent interest rate cut by the Fed, will increase the likelyhood that the scheme will be successful.

Bush Freeze on subprime rates
at Times

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