Spend 27 years in Congress and you’re bound to encounter more than one financial train wreck. But as Rep. Barney Frank, D-Mass., sees it, the meltdown in the U.S. housing market poses as much of a threat to the nation’s economic well-being as anything he’s encountered during his time on Capitol Hill.
More than 3 million homeowners will default on their mortgages this year, according to Moody’s Economy.com. That’s about 5% of all U.S. mortgages outstanding. Those defaults, in turn, are accelerating the pace of foreclosures and placing yet more pressure on housing prices - a vicious spiral that could hamstring the entire economy.
And as if that weren’t bad enough, mortgage behemoths Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), which together have a hand in half of all U.S. home purchases, have seen their share prices plummet amid rumors that they’ll soon require massive government aid to stay in business.
As chairman of the House Financial Services Committee, Frank is in the vanguard of the government’s response to the crisis. He spearheaded the much anticipated Housing and Economic Recovery Act, Congress’ most aggressive effort yet to beat back the onslaught of foreclosures and keep Fannie and Freddie afloat.
Money Magazine senior writer Janice Revell recently caught up with Frank in Washington a few days before President Bush signed the bill into law in late July.
Question: How on earth did the U.S. mortgage market get here?
Answer: We had too little regulation at a point of great financial innovation. Twenty years ago, most loans were made by someone who expected to be paid back by the borrower. And lenders who want to be paid back by the borrower are careful about who they lend to.
Then came this great innovation called securitization. Securitization means that I lend you money and quickly sell the right to be paid back by you to other people. Well, when the lender ceased to have an ongoing relationship with the borrower, a tremendous amount of banking discipline was lost. And it was much harder to replace than we thought.
Q. Where were the regulators during all of this? Why didn’t they step in?
A. Back in 1994, Congress gave the Federal Reserve the authority to ban irresponsible mortgages. Alan Greenspan, as a very committed anti-regulation conservative, refused - literally refused - to use that authority. Congress can give people authority; we can’t compel them to use it.
Ben Bernanke, to his credit, realized that it was time to use that authority. So he promulgated a set of rules on July 14 of this year to prohibit a lot of the mortgages of the type that got us in trouble. If Alan Greenspan had done 10 years ago what Ben Bernanke did this past July, we would have much less of a problem in subprime mortgages.
Q. Is the current mess a result of naive consumers being duped into horrible mortgages or is it a case of greedy consumers chasing cheap loans?
A. Some were misled, others took part in the deception. There were people, for instance, who lied about their incomes.
But we have made a mistake in this society. The assumption that everybody can be a homeowner is wrong. We pushed and encouraged people into home ownership - people who, in some cases, weren’t ready for it. You can’t act on wishes that are unrealistic without having negative consequences.
Q. You are the architect of new legislation aimed at stemming the rise of foreclosures. How is that going to work?
A. The initial approach taken a year ago by Treasury Secretary Paulson, who has handled this crisis very responsibly, was to get lenders to hold off on resetting adjustable-rate mortgages to a higher interest rate. The theory was that homeowners could refinance at a lower interest rate than the 11% or 12% rates they were facing.
But because of the drop in house prices over the past year, the problem now is that most of these people owe more on the house than it’s worth. Once the house is worth less than the loan, you can’t refinance. People hadn’t figured on that happening.
So we’re now telling lenders that if they agree to modify these mortgages so that the loan amount is equal to no more than 90% of the home’s current value, the Federal Housing Administration (FHA) will step in and guarantee the reduced mortgage against default. The homeowners will then be able to refinance into more affordable mortgages.
Q. But the lender still takes a big loss. Why would a lender go along?
A. We’re telling them, “Look, if the borrower defaults you’re going to take a loss anyway. We’ll guarantee that you’ll lose no more than you give up when you modify the loan.”
I think a lot of lenders will take advantage of that. And they understand that massive foreclosures are bad for the economy - and for them. Plus, this is purely voluntary. If you think you’re better off foreclosing on a homeowner, we won’t stop you.
Q. How much will this cost taxpayers?
A. The borrower’s mortgage is reduced by the lender, but the borrower gets no money from the government to pay off the new mortgage. Taxpayers are on the hook only if a borrower subsequently defaults on the reduced mortgage and the government has to take over the house.
Some of those houses won’t be worth as much as the mortgage that we had guaranteed. The Congressional Budget Office estimates that our proposal would cost taxpayers about $1.7 billion. But it would also prevent 500,000 foreclosures. That’s less than $4,000 for each avoided foreclosure.
Q. Why should responsible homeowners be forced to spend even a nickel of their tax dollars giving irresponsible borrowers a break on their mortgages?
A. Here’s why: Foreclosures do damage in concentric circles. The pain hits hardest on the people whose houses foreclose, but it also hits the entire neighborhood. If you’re a hard-working person making your mortgage payments and people around you are getting foreclosed, then your neighborhood starts to deteriorate.
The value of your home falls, and the entire city suffers because homes that used to generate property taxes are now eating up tax dollars. And when that happens, the whole economy suffers. So doing something about foreclosures helps the broader economy, not just the individual.
Q. Your legislation will also provide support to Fannie Mae and Freddie Mac should they need it. The tab could run tens of billions of dollars. Again, why should taxpayers bear the cost?
A. I believe Fannie and Freddie are better off than the market thinks. Over the long term the market is a very rational distributor of resources, but in the short term it can fall prey to hysteria. Sometimes you need to deal with that.
Part of the problem is rumormongering by short-sellers [investors who bet that a company's stock price will decline]. Our hope is that just by making U.S. financial support available, we’ll quiet the fears and eliminate any need for that support.
Q. This isn’t the first time we’ve seen housing prices fall. Why not just let the market work itself out?
A. Because it will cause tremendous pain that won’t be restricted just to housing. If the housing market simply deteriorates, the problem won’t just be foreclosures. Banks will fail. Pension funds won’t be able to pay workers their pensions - because they all own these securitized mortgages. Packaged mortgages have now become such a major part of the economic landscape that a massive failure of them would have serious consequences around the world.
Q. IndyMac Bancorp failed in July, the third-largest bank failure in U.S. history. Are we going to see more bank failures before all this plays out?
A. I’m sure there will be more bank failures, but we shouldn’t panic about that. Banks fail. That’s why we have deposit insurance. I don’t think we’re at the point where we’re going to have a rash of bank failures of the magnitude that could cause systemic failure.
Q. What has to happen to make you confident we’re not going to relive this mess all over again someday?
A. The Federal Reserve should be given the authority to exercise regulatory authority over investment banks. The time has come to regulate the securitization process. We need the kind of regulation that diminishes abuses but doesn’t stifle economic activity.
And we basically have to tell people who want to make mortgage loans something terribly radical: Do not lend money to people who can’t pay it back.
Credits: CNNMoney.com
