Correctly defining a problem is always the first step toward solving it. All three presidential contenders delivered major economy-themed speeches this week, but John McCain demonstrated a better understanding of the housing crisis than either of his potential Democratic opponents. His speech was short on specific policy proposals, but he declared himself open to “any and all proposals, based on their cost and benefits.”
Democrats criticized McCain’s speech for lacking specifics, displaying their fondness for laundry lists of government “solutions” to complex problems. The Democrats’ various proposals indicate that they have misdiagnosed the causes of the current crisis, attributing too much blame to “predatory lending” while absolving irresponsible borrowers who took out loans they could not afford. Conservatives needed to hear the Republican nominee present a broad and accurate overview of the crisis; the specifics can wait.
Rising home prices led lenders to lower their standards, McCain said. “Some Americans bought homes they couldn’t afford,” he added, “betting that rising prices would make it easier to refinance later at more affordable rates.”
Wall Street helped inflate the housing bubble, McCain argued, by betting big on mortgage-backed securities. When housing prices started to decline and foreclosures started to rise, a widely dispersed network of investors found themselves owning a lot of questionable mortgage debt, which sent investors into a panic.
In McCain’s formulation, irresponsible lending and borrowing created the problem, and uncertainty is at the root of its spread throughout the financial community. If accurate, this diagnosis demonstrates the folly of the Democrats’ proposed cures, which would reward irresponsibility and increase uncertainty among investors.
The meat of Barack Obama’s speech consisted of defending a plan he has co-sponsored with Senate Banking, Housing and Urban Affairs Committee chairman Christopher Dodd. Dodd and House counterpart Barney Frank have proposed allowing the Federal Housing Administration to pay lenders a cash fee in exchange for writing down troubled mortgages and refinancing them through FHA at lower interest rates. Obama insisted that the Frank-Dodd plan is not a bailout for lenders and borrowers who gambled on home prices. If putting taxpayers on the hook for billions of dollars’ worth of the riskiest loans isn’t a bailout, we’re not sure what is.
The Frank-Dodd plan would also reduce the size of the down payment needed to qualify for future FHA loans. Statistically, borrowers with little to no equity in their homes walk away from their loans more often. Thus, the Frank-Dodd approach, which Hillary Clinton also supports, would provide a taxpayer-insured bailout now and increase the likelihood of future mortgage defaults.
In his speech, McCain said he opposes reducing the down-payment requirement for FHA mortgages. This is the right approach. As McCain noted, rising housing prices during the boom encouraged lenders to push interest-only mortgages on borrowers who could never afford to pay off the principal. For their part, many borrowers misrepresented their ability to pay off these risky loans. Forcing the taxpayer to pick up the bill rewards both groups, and makes fools out of those responsible homebuyers who borrowed more prudently.
Hillary Clinton proposed an even worse approach this week when she called for legal immunity for mortgage servicers who freeze the interest rates on adjustable-rate mortgages. Adjustable-rate mortgages, or ARMs, are home loans in which the borrower starts out paying a low “teaser” rate of interest that resets to a higher rate over the course of the loan. Last December, the Bush administration brokered a deal between lenders and investors to allow cash-strapped borrowers to keep paying the teaser rate on their ARMs a little longer.
Clinton wants to go further and freeze the rates on all ARMs for five years. Mortgage servicers would probably go along with this, because they get paid the same amount whether the interest rate on a loan is 1 percent or 5 percent. But the people who own the mortgages — in many cases investors in mortgage-backed securities — have threatened to sue to protect the value of their investments.
To prevent that, Clinton has proposed providing legal immunity for mortgage servicers who cooperate. Servicers enter into contracts with investors that specify the circumstances under which they can work out deals with borrowers. Clinton’s plan would render these contracts null and void, contributing to the uncertainty that is paralyzing the financial markets. The reputation of American securities would be dealt a serious blow.
McCain’s approach, on the other hand, is to avoid policies that reward irresponsible behavior; to increase transparency in the financial markets; and to allow the Federal Reserve to act only when a systemic crisis appears likely. The Democrats’ knock on McCain is that he doesn’t know the economy, but his speech offered a better understanding of how markets work than anything the Democratic candidates have offered so far.