February 27, 2008 - Just what should the federal government do to ease the concerns of homeowners who are being foreclosed upon, or watching the equity in their homes go up in smoke? If you ask the folks in Washington, you are liable to get a different answer from each person you ask. All of this confusion could very well lead to more financial problems for the entire country.

Ben Bernanke, the chairman of the Federal Reserve Board has said that he will continue to lower interest rates to help stimulate the economy. Typically, lowering interest rates encourages people to borrow more money and to spend more. This causes the economy to expand.  But the FED has now reduced rates several times since August - when mortgage markets really started to have problems - with virtually no effect. There are a variety of reasons for this, but the largest of these has been that it has become much more difficult for lenders to sell their loans on the secondary market. More about that in a minute.

Lower interest rates can also have a dark side. They can lead to inflation. This is why when inflation is high, the FED typically increases interest rates. Increased rates lead to fewer borrowers and lower spending rates. This causes the economy to contract.

What happens if the FED lowers interest rates when inflation is high? Well, inflation will then get worse but their may be no expansion of the economy. No new job growth. No new home buyers. This happened when Jimmy Carter was president and it was know as "stagflation". Under Carter, the United States faced some of the worst economic conditions since the Great Depression. There is a very real possibility that we are heading into another similar period.

In order to get the economy back on track, several proposals have been made. One of these is to remove caps on the size of the mortgage portfolios or FannieMae and FreddieMac. These two government backed companies are responsible for making many home mortgages marketable on the secondary market. Legislators hope that removing caps on the size of their portfolios, the secondary mortgage market will heat back up and stop the current slide in housing prices.

Over the past two years however, Fannie and Freddie have both had significant management and regulatory issues that have led to significant losses. In fact, just today, Fannie announced it lost $3.6 Billion in the fourth quarter of last year. Freddie is expected to announce a $2.2 Billion loss for the same period, tomorrow. It doesn't sound to ACCESS like either company should be expanding the size of their portfolios. Instead, they need to be doing a better job of managing their existing portfolios.

But what do we know. The Office of Federal Housing Enterprise Oversight, the companies' regulator, said it would lift caps placed on the size of Fannie and Freddie's mortgage portfolios now that both companies are up-to-date on their financial statements. The caps will be lifted on Saturday despite both companies' account scandals.

Again, this is regulatory move based on "hope" rather than sound accounting. The "hope" is that lifting the caps on both companies will make it easier for homeowners to borrow money. In some cases, the plan may work. But the potential is there for a massive failure that could make matters much worse. And because Freddie and Fannie are both government backed, then any failure will have to be paid for by tax payers.

The one proposal in Washington which may provide many homeowners with the most hope is a proposal to reform the current bankruptcy law. Current law doesn't allow bankruptcy judges to alter the terms of most mortgages. In fact, the current law will allow the judge to alter mortgage terms on vacation homes and investment properties, but not on a primary residence.

The problem with the current law is that it leaves most people who declare bankruptcy with little or no hope of keeping their home.

As you might imagine, most lenders are vehemently opposed to a change in bankruptcy law. But they may be making their own situations worse. Without the ability to modify mortgages, many lenders will wind up having to foreclose on homes and then sell them at a significant discount. This puts the original homeowner out on the street, and the bank still loses money.  Some of these lenders are bound to go into bankruptcy themselves.

By adjusting the mortgage, lenders avoid the expenses associated with foreclosure and continue to collect money on the adjusted mortgages. At the same time, the homeowner gets a chance for a second start.

Unfortunately, President Bush has said that he will veto any changes to the bankruptcy law. He's against doing anything that will put taxpayer dollars at risk according to the White House. But it actually sounds more like he is trying to protect lenders at any cost. These are the same lenders that came up with all of the hair brained loan products that they have offered over the past eight years with impunity. The same lenders that paid additional bonuses to brokers and their own employees for placing homeowners into higher priced loans than they actually could have qualified for.

As an outsider, it would appear that the government has absolutely no cohesive policy to get the economy back in shape. And that is something for everyone to keep in mind as we go into election season.

by Jim Malmberg

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