Friday, February 15, 2008

Senator Clinton's Subprime Fix

The other day, I wrote:

Senator Clinton's proposal to freeze interest rates for five years, for example, is politics-over-policy to the point of being dangerous; Senator Obama's plan is much more sensible.

I've discussed a dislike with Senator Obama's pro-homeownership policies too, but there is huge difference between "not a step forward" and "dangerous"—those are fightin' words, and I should explain, because Clinton's mortgage interest freeze idea is insane.

The New York Senator has campaigned on a glass menagerie of policy prescriptions, tax credits for childcare and installing E85 pumps, tax deductions for broadband and energy efficiency, but her solution to subprime woes is a unique vomitorium:

FORECLOSURE MORATORIUM: Hillary will call for a moratorium on home foreclosures [for] at least 90 days so that a rate freeze can take effect and at-risk homeowners can get financial counseling to help them transition to affordable loans.

FREEZE ADJUSTABLE RATE LOANS: The rate freeze must last at least 5 years, or until subprime mortgages have been converted into affordable loans. A typical subprime adjustable rate loan is raising monthly payments by 30% to 40% for many families, causing a wave of housing defaults across the country.

We have two proposals: First, a ninety day siesta during which we defer foreclosures and, second, the state compelling the revocation and revision of millions of contracts.

There are over ten million adjustable-rate mortgages in the US (and over three million subprime adjustable-rate mortgages, if the senator chooses to constrain her plan). The enormity of such an intervention is unprecedented. What does it say to the mortgage market when the government favors the short-term over the long? What does this action suggest to lenders, foreign and domestic, about the US government's respect for contracts? And what does this plan say to the market about future adjustable-rate mortgages?

The proposal is overwhelmingly biased toward the borrowers; lenders are left shortchanged, with mortgages locked into teaser rates that in many circumstances are lower than fixed prime rates. This is wonderful news if you are a current borrower, and Senator Clinton's plan is sure to appeal to you. Yet, as with everything else in life, there is no such thing as a free lunch.

While current borrowers are obviously happy, their elation is at the expense of the lenders, who are expecting many of those adjustable-rate mortgages to pay out at the adjusted rate, but instead will have subprime—that is, risky—borrowers frozen into prime or better rates. Most important, this plan is bad news for future homeowners: Mortgage companies will have less money to lend toward new mortgages, since their cash flow is reduced by the frozen interest rates. And mortgagers will be more hesitant to lend, particularly to subprime borrowers, as they just had a bunch of contracts unilaterally rewritten. The net is less money available for home purchases and thus higher mortgage rates for the rest of us. Higher rates will put further downward pressure on home prices, exasperating the consumer credit crunch.

The senator's plan is going to burn down the forest to save a tree. It is a statist shotgun approach to a narrow (although real) market problem. The proposal is awful economics, and I believe the senator agrees. But its big and its bold and Mark Penn says its good politics.