Last Thursday the US Mortgage Bankers Association said that the rate of home foreclosure starts and the percent of loans in the process of foreclosure “are at the highest levels ever”. This association foresees that 1.5 millions of home loans will have entered the foreclosure process in 2007, up from 960,000 in 2006. Although subprime adjustable-rate mortgages (ARMs) just represent 6.8% of all loans, they will make up 43% of loans having started that process. These loans are precisely the aim of a Government plan unveiled last Thursday. Around 1.3 millions of subprime ARMs that were created between January 2005 and July 2007 and will face sharp increases in their interest payments in the next two years should be helped by the new plan, which intends to prevent a new escalation of home foreclosures. Why are politicians so concerned with foreclosures? Will the plan make a difference?
What the plan basically does is to strongly recommend lenders a five-year interest-rate freeze for those subprime ARMs whose receivers are able to go on paying at the low initial rates but risk falling into a foreclosure process if their rates are reset as established in their contracts. Why are politicians proposing this? Do they care so much about the votes of those risking their homes? Not necessarily. Their main concern is to avoid recession, a possibility that would have a much wider electoral potential. The key question here is the housing market. Investment and sales are already tumbling for more than a year. The inventory of existing homes available for sale has increased to 4.4 millions from 2.9 millions at the start of 2006. This means an increasing downward pressure on home prices, which have decreased by 5% in a year. Home foreclosures necessarily translate to a higher home inventory and the consequence is even lower prices. And why are lower home prices so unwelcome? Private consumption is the answer. The lower home prices are, the lower the net wealth of consumers will be. A 20% decrease in prices could reduce residential net wealth of consumers by 40%. If we add a gloomier outlook for equity and the fact that the consumer saving rate is at historical lows below 1%, the threat of a sharply reduced spending becomes very real.
Will the Government plan help? Probably not enough. Although the first wave of foreclosures have been very much related with subprime ARMs, the role of other loans (fixe-rate or prime) is rapidly increasing. Furthermore, the plan will probably cover a much lower number of loans than the 1.3 millions foreseen by the Government. Foreclosures will go on increasing and, together with a depressed demand of homes, they will go on pushing prices down. Lower asset prices are a much more powerful trigger of defaults than interest-rate changes and thus even many of those loans supported by the plan might end up defaulting.
Is there anything else authorities could or should do?