With foreclosures reaching new heights, a downturn in housing has become a problem for the whole economy, not just for troubled subprime borrowers.
That's why President Bush announced Thursday a voluntary private-sector plan to freeze interest rates for many borrowers at risk of losing their homes.
The problem: Economists say the freeze is only a partial answer to the challenge.
That doesn't make the move unimportant. But when it comes to fighting a potential recession in the economy, the interest-rate cut expected next week from the Federal Reserve may accomplish more.
"There's no question that [housing] is the big factor causing growth to slow and raising recession risks," says James O'Sullivan, an economist at the investment firm UBS. But to ease the crunch, "the main tool has to be monetary policy." Still, analysts say that it's time for many tools, not just one, to be deployed.
"Desperate times call for desperate measures," says Jared Bernstein, an economist at the Economic Policy Institute, a left-of-center think tank in Washington. "Housing experts have said this downturn is extremely unique and severe."
One sign of that emerged Thursday before Mr. Bush spoke. The Mortgage Bankers Association announced that 0.78 percent of all US mortgages started the foreclosure process during the quarter from July to September, the highest ever reported by the organization. The delinquency rate – the share of loans 30 days or more past due – rose to 5.59 percent, the highest since 1986, it said.
Under the plan announced by Bush, many borrowers who face an upward reset in their interest rate will be allowed to keep their current mortgage payments for a five-year grace period.
Since the initial interest rates are sometimes called "teaser rates," the plan has been dubbed the "teaser freezer."
The affected borrowers would include those with adjustable-rate mortgages (ARM loans) who show that they won't be able to pay once the loan resets, but who can keep paying the current amount. When other limitations are factored in, analysts say the move will affect only a small subset of an estimated 2 million homeowners facing an ARM reset in the next year or so.
"In theory, the plan could help as many as 750,000 subprime homeowners," Mark Zandi, chief economist for Moody's Economy.com, told Reuters. "In practice, my sense is that it will probably help, at best, about 250,000 homeowners."
The plan, brokered in part by US Treasury Secretary Henry Paulson, comes at a time when banks appear to have fallen behind in dealing with the tide of mortgage defaults. The goal is not just to mitigate the foreclosure problem, but to soften its impact on the wider economy.
The danger is a downward spiraling vortex. The more homes go into foreclosure, the more inventory comes onto the housing market at a time when home prices are already falling. That puts more borrowers at risk of being "under water," with homes worth less than the balance on their loans.
This, in turn, spirals into the performance of the economy. Overall consumer spending takes a hit when the key household asset – the home – falls in value, a fact not lost on Bush administration officials.
"They deserve our applause and appreciation for undertaking to solve what's starting to look like a market failure," says Mr. Bernstein. "The industry itself doesn't seem to be capable of organizing to address this in a meaningful way."
In addition to announcing the goal of greater forbearance, Bush called for Congress to pass legislation that he supports to bolster the role of government-sponsored enterprises, such as Fannie Mae, in helping homeowners get mortgages and refinancing them.
"The Congress hasn't sent me a single bill" to help homeowners, he said.
For their part, Democrats have called the president's plan too timid. Some, including Sen. Hillary Clinton of New York, would like to see a moratorium on foreclosures.
Bush's approach to the housing crisis also has critics on the right. Many free-market advocates see the rate-freeze plan as counterproductive meddling by government. Secretary Paulson, in comments to the press, emphasized that the plan is voluntary.
"This is a private sector effort," he said.
The move toward a system for modifying loans en masse when possible, rather than foreclosing, could help banks and investors who hold mortgages, because they stand to lose if home prices continue falling. Each foreclosure can cost banks $50,000, and sometimes more, when they resell the home in a distressed market.
By some forecasts more than 1 million homes could enter foreclosure next year, even with the new rescue plan.
The plan focuses on subprime borrowers – often those with weak credit history – who bought since 2005, when home prices were near their peak. As the value of their homes fall, they can't resell and pay off their loans if they have trouble making payments.
On these loans, the initial "teaser" rate was not necessarily very low. It could be 8.5 percent on a 30-year loan where resets begin after the second year.
So freezing rates doesn't leave lenders with nothing.
But it does avoid a "payment shock" for borrowers, which could amount to $350 or more per month, experts say.
A central challenge in the current housing crisis has been that after most subprime loans were made, they were generally packaged into mortgage securities for investors to buy. Now, those investors own the rights to the mortgage payments, which raises legal hurdles when determining whether loan-modification deals are in the investors' best interest.
Paulson said that investors are "on board" with the plan, however. "The risk of litigation should be manageable."
The American Securitization Forum, which represents those who securitize mortgages, was engaged in developing the plan alongside mortgage bankers.
Eric Rosengren, president of the Federal Reserve Bank of Boston, outlined a close link between housing and the wider economy in a speech this week.
"The current problems in the subprime market are heavily dependent on economic conditions," he said. "Our research suggests that the foreclosure crisis will get worse before it gets better, but our forecast is quite dependent on how far house prices fall."
Where the housing market heads will be vital not just for the fate of subprime loans, but for the US economy. Mr. O'Sullivan doesn't predict a recession, but he sees growth falling perilously close to zero before it begins to recover late next year. He forecasts weak economic growth of 1.8 percent next year.
"Home-price decline is one of the factors that could lead to recession," says Michael Cosgrove, publisher of the EconoClast newsletter in Dallas. And with prices falling, "the Fed can ease [interest rates] significantly at this point without inflation being a concern."