First, before everyone goes crazy, let me say I feel sorry for and can empathize with those who are facing foreclosure. Mostly, in this article, I am talking about those who are facing high adjustments on their ARMS (Adjustable Rate Mortgages) and will ultimately be kicked out of their homes. I feel sorry. But, I think helping them out with a freeze or assistance is bad economics and bad for the US economy. Let me explain why.
The plan being looked at right now is described in "Rate Freeze Plan for Arms Gains Traction" and it appears to be a plan where people who have too much debt will be allowed to "freeze" their rates where they are. The article states:
"If you've got a 7% adjustable mortgage that's about to skyrocket past 10%, getting a break may get a lot easier. One solution to the foreclosure problem gaining traction would freeze rates at lower levels."
Sounds nice enough but here is the "more of the story":
"Judging from other lenders' plans, a reset freeze would be available
only to those borrowers judged unable to make payments at the reset
rates.
That would be determined based on a borrowers' debt and
income, according to Pfotenhauer, who could not specify what standard
Hope Now will use. Historically, the lending industry judged
affordability in this way: Total debt payments each month should not
exceed 36% of total income. But in a bill sponsored by Barney Frank (D-
Mass.), that threshold is set much higher, at 50%, according to
Pfotenhauer."
This puts us in an interesting position whereby we are offering welfare payments to home owners yet we reject providing health care to kids of poor families.
Now, the real problem I have with this is wrapped up in the term Moral Hazard.
Moral Hazard is defined as (From Investopedia):
"The risk that a party to a transaction has not entered into the
contract in good faith, has provided misleading information about its
assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles."
In this case, we are talking about the issue of people taking unusual risks to earn a profit. That is EXACTLY what ARM borrowers were doing. They were buying far more house than they could afford, taking a large risk loan and hoping and praying that the fast growth in real estate values would offset their risk. Anyone who has been buying Real Estate since the '80s or was even awake during the '80's knew that borrowing for a short period like this was a huge risk. I would always ask people why they were willing to take such a huge risk when the bank was willing to lock you in for 30 years? In a 30 year mortgage, the bank takes all the risk of inflation with you bearing very little risk.
Of course, for that, you pay and that is why 30 year loans were slightly more expensive than ARMs.
But, people took the huge risk and then used their home as a piggy bank.
Here is the punchline: If the banks and the Government "bail out" the ARM borrowers by freezing their loans and, especially if they do it by only freezing those who cannot "afford" the new payment, then the Government and banks have essentially INSTITUTIONALIZED and REWARDED moral hazard! The incentive moving forward will be to join the crowd and take crazy risks because if enough people do it, then the banks cannot fail, and therefore they will just "forgive you" when the undo risk causes things to come crashing down.
No, friends, this is an example of public policy gone bad. They were called risky loans for a reason. While this bail out may "feel good" it is very bad financial and public policy and should not be allowed. In the long run, people have to learn that too much risk can cause bad things to happen otherwise they will continue to take huge risk.
And that would be even worse.