How to Handle the Subprime Crisis

The subprime crisis poses a huge threat to our economic well-being. If not handled correctly, it could feed into a vicious cycle of foreclosures, falling land prices, falling consumption, layoffs, and bankruptcies. The first priority must be to try to keep people in their houses. International and financial market confidence in the American economy has already eroded significantly, and things could get much, much worse.

Regardless of any feelings of sympathy towards the homeowners with subprime mortgages, this makes the most economic sense. Lenders are likely to recover much more of the principle of the home loans from the current occupants than they will by foreclosing and trying to sell off the property in a crashing market. And as long as lenders are foreclosing, the property market will crash. Thus it makes economic sense to renegotiate loans. In most cases, occupants were able to keep up with payments while introductory interest rates applied, so a freeze in interest rates should work in those cases.

One obstacle is that the original lenders of subprime mortgages have bundled them into derivative packages to be sold to investors in the financial markets. This makes it difficult to renegotiate the terms of loans. The solution would be for the government to purchase the bundled loans at market value (i.e. at a substantial discount from face value), unbundle them, and then renegotiate the terms of the loans with the borrowers. Franklin Roosevelt did something very similar in 1933 when he created the Home Owners Loan Corporation (HOLC) at a time when 1000 families were having their houses foreclosed on everyday.

The idea is not intended to be a give-away. Indeed, the HOLC actually turned a profit for the government. It is not intended to bail out borrowers who knowingly got in way over their heads, who purchased second homes, or who were simply engaging in real estate speculation. However, there are many homeowners who are being caught as lower introductory interest rates are giving way to much higher variable rates. In many cases these borrowers were relegated to subprime loans due to arbitrarily set credit ratings or ever due to racial discrimination.

As for the banks, it is important for the government to get a grasp on the extent of exposure our banking institutions have to subprime loans. Regulatory authorities should perform prompt audits of banks, and banks with excessive debts should be liquidated or nationalized. Banks that are shown to be undercapitalized could be injected with public funds in exchange for partial government ownership and acceptance of government conditions on management. Bank managers responsible for the decisions that led to such financial problems at their banks should resign and face legal proceedings where appropriate. It is obscene that some of the bank executives responsible for the biggest losses have been given massive retirement bonuses.

Finally, we must acknowledge the responsibility of the Federal Reserve under Alan Greenspan for allowing the housing bubble and subprime crisis to happen in the first place. Eventually the Federal Reserve should be abolished and responsibility for monetary and financial policy placed in the Treasury Department or a newly created executive agency and overseen by Congress.