Wednesday, December 05, 2007

Freezing Rates on Bad Loans

To help deal with the current mortgage crisis, President Bush has announced a potential plan to freeze interest rates on some home mortgages. This is to help avoid foreclosures in cases where rates are scheduled to rise sharply in the next 2-3 years.

I think this is a bad idea for several reasons.

1. Since this will increase the losses to the banks and investors that backed the mortgages, the cost of future mortgages will therefore increase - either through higher interest rates or higher fees. This is because lenders will have to raise the future cost of borrowing to account for the possibility of losses being incurred by unpredictable government intervention.

2. This will reward individuals who took out loans they could not afford, while penalizing those who correctly calculated that they could not afford these loans. This type of perverse reward system will encourage people in the future to make investments they can not afford, with an expectation that the government will bail them out if problems arise.

3. Backers of the plan make the flawed argument "it is better for the lenders if the borrower can keep the house, than for there to be a foreclosure where the lender will incur much greater losses." Lets examine the two possible scenarios to see why this argument is flawed:

(Scenario a) If the lender is better off under the rate freeze plan:
If this is the case, then the lender will freeze the rate on their own, without being forced to do so by the government.

(Scenario b) The lender will suffer additional losses under the rate freeze plan:
In this scenario, the government is forcing losses upon the lender for a mistake that was made by the person who took out the mortgage.

I think this proposal will take a bad situation and make it worse.


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