There is a mortgage crisis going on. Millions of people are in foreclosure and there's more trouble ahead. The administration and Congress are belatedly debating about what to do about the rising default rates. Congress wants greater intervention, including expanding the abilities of Fannie Mae and Freddie Mac to buy renegotiated subprime mortgages. Fannie Mae and Freddie Mae buy billions of dollars in mortgages each year and package them into securities which can be traded. Right now the financial markets are in a panic because no one trusts the mortgage-backed securities Wall Street created, exotic instruments such as Collateralized Debt Obligations. Fannie Mae and Freddie Mac are government-sponsored finance companies, so they would be able to trade their securities because they're backed by the U.S. Treasury (up to $417,000 per mortgage). I mean, if the Treasury fails, we're all up the creek.
Congress also wants to give bankruptcy judges the ability to revise mortgage contracts, much as they already do when they're sorting out other kinds of payments to creditors.
One reason there is such a crisis is because the administration, the Treasury Department, et al took the laissez faire approach. They didn't want to squelch the creation of "innovative" financial structures like collateralized debt obligations (which I wrote about here before). No one knew what the hell these C.D.O.s were anyway, which is now becoming obvious because no one wants to buy them. They were supposed to spread out risk among a lot of parties, which would diminish the risk (theoretically). The credit rating agencies like Moody's and Standard & Poor's agreed eagerly and gave these vehicles AAA ratings, the highest you can get. Unfortunately, they are turning out to be worthless, or at least that's what investors think and that's what counts. Credit is a confidence game, and once you lose the confidence of your investors, you're in trouble.
These problems are weighing in on foreclosure rates. The July 2007 rate was double that of a year ago. According to The New York Times, 8/28/07:
The Deutsche Bank estimates that about $400 billion in subprime loans [and adjustable rate mortgages] are scheduled for rate increases of 30% or more by the end of 2008.
Why should we, the American people, bail out homeowners if they lied about their ability to repay or borrowed beyond their means to purchase a home, aside from the fact that it may be the decent and most money-wise thing to do? Because we already bail out the Big Players.
According to James Grant, the editor of Grant's Interest Rate Observer, Wall Street acts the way it does, ratcheting up risk, speculating wildly, then pretending there is no risk, because it knows it will be bailed out by the Federal Reserve (which is actually us, the taxpayers). The Fed will heed Wall Street's cries for interest rate cuts, easing credit woes by making it cheaper to get.
Nobody seems to care if prices rise precipitously. It's only when they fall that Wall Street gets uneasy and starts to bellow for a bailout. When a huge hedge fund collapsed in 1998, the head of the Federal Reserve at the time, Alan Greenspan, swiftly cut the interest rate 3 times in rapid succession.
Thus fortified, lenders and borrowers, speculators and investors, resumed their manic buying of technology stocks. That bubble burst in March 2000.
If you really believe in letting the market do its work, price declines are the way of cleaning out bubble excesses when people get carried away and bid up prices way out of proportion. For instance, during the dot-com bubble just alluded to, some domain names were trading for triple digits a share even without profits or a business model. Declining prices are a return to the rule of reason.
But because Greenspan flooded the market with cheap credit in 2002-2003, prices soared, especially for housing. People jumped in rationally, because they knew even if their speculations were outrageous, the Fed wouldn't let them fail. The Fed would bail them out with interest rate cuts. So they borrowed lots of money at super low interest rates and went to town.
As Mr. Grant says:
[C]apitalism without financial failure is not capitalism at all, but socialism for the rich.
Who would you rather bail out (assuming you had to bail out somebody), a defaulting mortgage holder in danger of losing his or her home or a Wall Street hedge fund manager fresh from a private Rolling Stones concert?