For many, the dream of owning a home has vaporized as the facade of cheap mortgages, which seemed so normal from 2002 to 2006, has crumbled. Federal officials have reacted well, letting markets expose the error of their ways and laying the ground for more sustainable home ownership.
The Federal Reserve hasn't been complacent as stock markets, hedge funds, and mortgage brokers go south and thousands of new homeowners are forced into foreclosure. To keep the short-term credit pipes from freezing up for everyone, the Fed has loaned billions to big banks. These temporary infusions aren't a bail-out – the move actually earns interest for the Fed – but rather "crisis prevention."
Meanwhile, Treasury Secretary Henry Paulson has wisely warned that this necessary bubble-bursting will "extract a penalty" on economic growth. How much? For now, bad home loans may amount to less than one percent of the nation's GDP.
Still, the US could now face its first, long-term national drop in house prices since the 1930s. That prospect puts pressure on the Fed to drop interest rates, especially heading into election season. Such a step was necessary after the 1987 stock market crash, the 1998 collapse of the Russian economy and a giant US hedge fund, and the Sept. 11 attacks and tech-stock crash in 2001. But not now.
A rate cut, besides possibly worsening the current inflation, would only help salvage many of those people and institutions who contributed to the big gamble on risky, subprime mortgages.
A market reckoning is in order, one that teaches lessons as the receding tide lays bare all past mistakes and irrational exuberances: zero-down loans for marginal buyers, fraud in lending, conflicts of interest in rating agencies, the opacity of risks in "bundled" mortgage securities – and the Fed's own looseness on interest rates. Home buyers are learning a stern lesson if they didn't read the fine print or ask the right questions. Financial illiteracy is no defense, especially when there's no downpayment or checking up on stated income.
Much of the market crisis lies in simply not knowing which firms remain exposed to high-risk mortgages. (And more than 2 million adjustable-rate mortgages may be reset higher next year.) The financial industry has done well over the past decade to spread such risks by repackaging US mortgages and reselling them as debt on global markets, enabling cheaper mortgages. But it has fared poorly in accurately measuring those risks and making them transparent. More time is needed to reevaluate the remaining risks – another reason for the Fed to be patient.
Help for low-income Americans in buying homes can come from the two government-related mortgage giants, Fannie Mae and Freddie Mac. But the limits on their level of debt must remain for these special, loosely regulated institutions.
If the Fed, or even Congress, tries to rescue the financial industry, they could create the "moral hazard" of the industry repeating its mistakes and worsening the prospects for home buying. The best action for now is to let this house of cards fall further and help the industry become more honest and open. The American dream of home ownership can only benefit if mortgages are built on the rock of honesty.