The Teaser Freezer and the Housing Market Meltdown

With millions of people facing the loss of their home over the next couple of years, President Bush was finally prompted to take serious action. For homeowners with subprime adjustable rate mortgages (ARMs), President Bush proposed freezing in the relatively low "teaser" rate on mortgages that would otherwise reset to higher interest rates in the next three years.

This measure can help hundreds of thousands of moderate-income homeowners. However, it is poorly targeted. It will not provide any assistance to most of the moderate-income homeowners in need of assistance. By contrast, my "own to rent" proposal does a far better job of targeting those in need. The teaser freezer proposal also suggests President Bush and his advisers still do not recognize the seriousness of the housing crash.

The list of people left out in the teaser freezer plan is long. First, it does nothing to help homeowners' whose mortgage had already reset to a higher rate; it only affects resets scheduled for after January 1, 2008. It does nothing to help people who took out subprime fixed-rate-mortgages, many of whom also now find they can't meet the expenses of homeownership. Predatory lenders who were dishonest in pushing ARMs were no more honest in explaining the costs of homeownership to buyers who insisted on fixed-rate-mortgages.

The Bush plan also only applies to people who had subprime mortgages. This means a family living across the street from a subprime mortgage holder, with an identical income, who had always paid all their bills, and therefore qualified for a prime mortgage, would get no benefit from the Bush plan. It is important to recognize prime mortgage holders are struggling also. The default rate on prime ARMs has more than tripled over the last three years. It seems peculiar to penalize people who have good credit ratings.

In the same vein, if a subprime mortgage holder's credit rating has improved so that they now qualify for a prime loan, they are also excluded from the Bush plan. While in principle these people can arrange a new loan at a lower interest rate, this will not circumvent prepayment penalties in many contracts. Also, in the many areas where house prices have fallen, homeowners will not be able to get a new loan since their homes are now worth less than their mortgages.

This raises perhaps the most important point: The teaser rate is itself unaffordable to many subprime homebuyers. The teaser rate on subprime mortgages averages between 7 percent and 8 percent. Many subprime homeowners were only able to pay even this rate by borrowing against equity. A freeze at the teaser rates will not prevent these people from losing their homes.

The core problem is millions of people bought homes in the middle of a housing bubble and they are now seeing prices plummet. Predatory mortgages worsened the situation of many, but the real problem is falling housing prices, not the mortgages. If house prices were still rising by 10 percent a year, even the worst mortgage would be affordable, since homeowners could always meet their payments by borrowing against newly created equity.

The basic feature of the own to rent plan is it changes the rules on foreclosure so homeowners facing foreclosure would have the right to rent their home indefinitely at the fair market rent. The judge overseeing the foreclosure would use an independent appraiser to determine the fair market rent in the same way banks use appraisers to determine the market value on a home before issuing a mortgage. This rule would guarantee homeowners would have the option to stay in their home, at least as renters.

Most importantly, the plan gives lenders a strong incentive to negotiate terms under which homeowners can maintain ownership in their houses by making foreclosure a much less attractive option. Lenders do not want to become landlords; so, in most cases, they are likely to work out new mortgage terms the homeowners can afford rather than go through the foreclosure process. This is exactly the outcome we should want.

The plan can also be restricted by time and house price. For example, the change in foreclosure rules can be limited to mortgages taken out before July 1, 2007, and only apply to houses that sold for less than the median price in an area.
Of course, even the own to rent plan will not make this a happy situation. Homeowners nationwide stand to lose as much as $8 trillion in equity, an average of $110,000 per homeowner. This will cause enormous pain to homeowners and lead to much larger disruptions in the credit market than we have already seen. There is no way to fix the problem - the key is to prevent such bubbles from growing in the first place. On this score, President Bush, along with Alan Greenspan and Ben Bernanke, were hugely negligent. The economy and the country will pay an enormous price for this failure.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer ( www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.