The United States is an economic powerhouse. The economic engine of the US has more output than any other nation on the planet. In fact only recently and due to the fall of the dollar has the EU surpassed the US in dollar output. The EU has 50% more people than the US and had the dollar not slid or had the slide stopped in mid/late 2006 the US would still be ahead of the EU in USD output as our real economic output has gone up considerably the last few years. However, this economic engine has begun to sputter.

I believe the government needs to take a series of steps to help smooth out the economic bumps in the road. The government is partially responsible for this current economic slowdown and as a result they need to help limit the impacts of the recession. We need to limit mortgage adjustments for loans that are resetting. The fed chairman needs to keep rates relatively low. Finally, it is imperative that corporations bear some responsibility for their bad decisions. More on my recommendations in a bit, first a brief history in how/why we’re in the mess we’re in.

The US began to show signs of possible recession in mid to late 2000. As Bush took office it was obvious the US would enter a recession and it did. September 11th 2001 terrorist attacks complicated matters and sent the financial and capital markets onto a roller coaster ride. In response, then Federal Reserve Chairman Alan Greenspan began cutting rates much further than the months leading up to September 11th. Rates dipped to all time lows and then the Mr. Greenspan decided to keep rates low for an extended period of time.

The lowering of rates has long been a tool of the fed to encourage borrowing amongst consumers and businesses. Cheap money allows for cheaper capital investment, increased ROI and as a result helps to spur economic growth and keep the economy more stable in times of recession. As rates dropped business investment began to increase, but long term government bonds and T-bills also began dropping, a combination of interest rate cuts and a fall in bond rates led to a drastic fall in mortgage rates.




The federal funds rate was below 2% for more than 3 years and at 1% for a full year. This helped fuel the housing boom in many areas of the nation. Housing demand began to increase rapidly, home builders began hiring employees and building homes at a record pace. Banks having record demand for loans and profits rising began looking for new ways to make more money. As the well qualified buyers began to take out home equity lines of credit or upgrade to bigger homes, banks began taking more risk on lower earners and potential buyers who would not ordinarily qualify for homes. Furthermore, these lending institutions could at a later time sell the loan to another lending institution.

Loaning money to subprime borrowers and giving them an opportunity to buy a house is not a bad thing, it allows people an opportunity to buy who may not otherwise have had a chance to buy. Also, owning a home is one of the best ways to build personal wealth, so buying a home has huge benefits for those that choose to do so. However, as fed funds rates stayed low and banks began seeing the huge profits available to them via subprime loans they began to push them harder. ARM’s or Adjustable Rate Mortgages or interest only loans became very popular. These loans temporarily lower the payment on a home. In the case of ARM’s they adjust up at a later date, interest only loans, are just that, interest only, depending on how the loan is structured the buyer may not ever make a principle payment on the property. These turned into profit machines for banks as they could get buyers into a house, collect the closing costs which on most subprime loans are 4,500 dollars or more, then sell the loan to another institution getting it off their books.

To really push things over the edge, buyers were uninformed and in many cases did not want to think about a future where they could not make their payments. They plunged head first into loans they may or may not be able to afford in two, three or five years. Well guess what…now its two, three and five years later. These mortgages are beginning to reset at a record pace, foreclosures for 2007 were up substantially. As rates reset payments could go up 25, 50 and in some cases 100%. A full doubling of someone’s home payment would almost certainly result in eventual foreclosure.

There are approximately 1.3 to 1.5 trillion dollars in outstanding subprime loans. Most optimistic estimates of subprime foreclosures is about 650,000 homes. Some of the more pessimistic estimates are 2.5 to 3 million homes. Couple these numbers with what are normal foreclosure rates and you have a number ranging from roughly 1.75 million homes to a substantial 4 million homes that could enter foreclosure the next 30 months.

This has a broad economic impact on those of us who have normal fixed rate home loans, live in an apartment or even with your parents. As foreclosures rise home values fall. For every foreclosure that occurs in a given neighborhood property values fall 1%. For every 1% increase in foreclosures violent crime increases more than 2% (this according to money magazine Feb, 2008). Considering foreclosure rates could reach 2% that translates into an overall increase in violent crime of about 4% and substantial decrease in property values. As property values decrease the ability to get lines of credit go down. People begin to spend less and the economy grinds to a hault. People lose jobs, home loan defaults go up some more. Businesses can not invest in capital because the credit markets are tight. Banks are losing money and do not have capital to lend businesses. It is a tough situation and while it is true the market could and would correct itself, I believe it would lead to a substantial recession and stagnant wages similar to the 75-77 recession.

So how do we fix this mess? Well I believe the new Fed Chairman Ben Bernanke is taking correct steps now by lower rates. However, he must be careful that he does not lower rates too low and only prolongs the problem. At the current 3% rate I do not think that is a problem. I think the Fed should hold rates at 3% +/- .5% for 12 to 15 months. Then raise rates to 3.25 or 3.5% by summer of 2009. I would then raise rates slowly from 2009 to the end of 2010. This will help alleviate the mortgage reset issue that most subprime borrowers are facing. Payments will adjust up but they will only adjust up a percentage or two instead of some of the four, five and six percent increases many were experiencing.

On top of this I think that congress needs to closely monitor the situation and seriously considering capping ARM resets at .5% per year or a 1% per year max. This would allow people’s paychecks to absorb these increases in their monthly housing expenses. Lets not forget that these people SIGNED up for these mortgages. There was no gun to their head forcing them to do it, they should absorb some increased costs as their contract specifies. However, I do believe that banks and/or real estate agents in many (not all) cases were simply being greedy. They wanted to make a sale, collect closing costs, then sell the loan on the open market. Almost instant profit with little risk for the banks.

Banks should bear more responsibility than the individual buyer. Banks should be forced to deal with the lower rate adjustments and I do not really care if they lose money for a year or two as a result. By keeping a cap on rate adjustments of 1% or less/year you keep owners in their homes, you stabilize (but flatten) home prices for several years. But you also keep banks from having to deal with foreclosure proceedings which would more than likely be almost as bad as dealing with the lower rates and smaller income streams from the loans. So this is as close to a win/win situation as we can get in our current economic mess.

I hold government 50% responsible for this fiasco for keeping rates too low too long. I hold banks 30% responsible and individual buyers 20% responsible for these financial problems we face. As a result I am ok with a congressional mandate that caps rate adjustments for loans made between 2002 and 2007. This should prevent a substantial housing crash and loss of wealth for ALL Americans and should help keep the economy stable in the coming years.

When it comes to dealing with the recession aspect of this mess, fixing the housing problem should help keep a recession fairly mild, unemployment may spike to the upper 6% range if we can keep the housing market from imploding. However, things shouldn’t get too bad unless the government completely mishandles the situation through over regulation or the fed abruptly changes rates up or down. Bernanke is a very smart man and I do not see him reacting in a panicked manner to the situation. I think the current 3% will help adjustable rate mortgages adjust lower and should by itself save 500,000 or even a million homes from going into foreclosure.