It’s Socialist America

So, is America careening into socialism after the castle of crony capitalism collapsed?

We all know that unless the US and other developed European markets recover from
the current crisis, India cannot maintain robust growth rate of even 5-6% in midterm.
And for the US economy to rebound it’s inevitable that their housing crisis settles soon.
If it’s too important for the US and all of us, we must be curious to know what corrective
steps the new administration in the US is going to take. Here we will discuss what are
policies the US government has formulated to counter the crisis and how effective they
are.

Background

About 6 million house owners have either faced foreclosure or are at risk of foreclosure
across the US. Home prices in cities across the country have fallen by more than 25%
since 2006 and in some cases by 43%. In Obama’s words “In the past, if you found
yourself in a situation like this, you could have sold your home and bought a smaller
one with more affordable payments, or you could have refinanced your home at a lower
rate. But today, home values have fallen so sharply that even if you make a large
down payment, the current value of your mortgage may still be higher than the current
value of your house. So no bank will return your calls, and no sale will return your
investment”.

Let’s first understand what went wrong in the US housing sector. In 2003 there was a
great demand for American home loans. To meet the growing demand for the home
loans, the mortgage lenders like Fannie and Freddie tempted to relax their norms for
lending. Since the values of houses in the US have been on continuous rise ever since
the World War II, everybody assumed that it would continue to move upward only. As a
result a time came in 2005 when almost anyone in the US could buy a home without
income proof, other assets, credit history or sometimes even without a proper job. Such
loans were called NINA which stands for "No Income No Assets". To make things
worse, interest rates began to rise during 2004-2006. This led up to a chain of defaults
making home prices going down and down. This housing bubble is the root cause of
current global crisis which has inflicted economies across the world. (For more details
refer World Financial Crisis II dated October 13, 2008).

Corrective measures

President Obama has announced a $275 billion program that will move to cut mortgage
payments by matching reductions lenders make to interest payments to 31% of the
borrower’s monthly income. The Treasury will also buy up to $200 billion of preferred
stock in Fannie Mae and Freddie Mac, and detailed guidelines are due to be released
on March 4. It is necessary to discourage foreclosures because it may cause further fall
in the prices of nearby homes creating the potential that even borrowers who make
every payment suffer. This program has four components:

Deepak Tiwari 1. Refinancing in cases where home value has fallen below mortgage value
Research Analyst
In order to support as many as 4-5 million families which are facing foreclosure,
deepakt@arthamoney.com refinancing (up to 105% of home value) has been allowed in cases mortgages exceed
home value. Refinancing means reducing interest rate. Though Fannie and Freddie
T: + 91 22 4600 0345
would receive less money in payments due to reduced rate, this would be negated by a
reduction in defaults and foreclosures. This plan could stop the slide in home prices
due to neighbouring foreclosures by up to $6,000 per home.

Feb 26, 2009 For Private Circulation only

 2. Cash incentives amounting to $75 billion

New incentives have been created so that lenders work with borrowers to modify the
terms of sub-prime loans at risk of default and foreclosure under Homeowner
Affordability and Stability Plan. But the lender cannot reduce the interest payments less
than 31% of the borrower’s monthly income. This plan will enable about 3- 4 million
homeowners to modify the terms of their mortgages to avoid foreclosure.

3. Fresh capital injected for new mortgage lending

The US treasury will provide up to $200 billion in capital to ensure that Fannie Mae and
Freddie Mac can continue to stabilize markets and hold mortgage rates down.

4. Reforms in housing sector

The government is determined to pursue a wide range of reforms designed to help

families stay in their homes and avoid foreclosures. It includes reforming the
bankruptcy rules to enable judges to reduce home mortgages on primary residences to
their fair market value as long as borrowers pay their debts under court-ordered plans.

The program emphasizes not to provide money to speculators, and to support to the
working homeowners who have made every possible effort to stay current on their
mortgage payments. Thus only owner-occupied homes qualify and no home mortgages
larger than the Freddie/Fannie conforming limits will be eligible.

Flaws in the policy

Swaminathan S A Aiyar in his article in Economic Times dated Feb 25, 2009 observes:
Refinancing mortgages up to 105% of home value will be disastrous if home prices fall
further. The crisis owes much to the slack lending standards of Fannie Mae and
Freddie Mac, yet the Obama Plan provides these agencies additional capital to extend
sub-standard lending. This risky approach will work only if home prices rise soon.
Otherwise, it will cause another housing crisis within two years.

He criticizes the housing plan for ignoring two basic housing fundamentals and calls for
reforming them. First, non-recourse mortgages policy that means loans are secured
only by the house and not by any other assets belonging to the borrower which
encourages wilful default. Second, subsidizing ownership and discouraging renting
which is the root cause of the current crisis. He argues that in a market system,
monthly mortgage payments are necessarily higher than monthly rents. People with
uncertain incomes should rent cheaply, not borrow expensively to buy houses. Renting
is an essential part of a housing market, not a deficiency. He advises that the
governments should build low-cost houses and rent these cheaply to people with low or
uncertain incomes instead of subsidizing ownership.

There are others too who term this plan as wasteful help and believe that money is
going to less responsible borrowers that are now counting on a refinancing to be able
to keep their home. Matt Koppenheffer is one of them.

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