Tuesday, July 1, 2008

Mortgage Payment Resets Peak

Old MacDonald had an ARM.

The payments started low.

Then the payments took a jump,

And caused a lot of woe.

With a jump, jump here.

And a jump, jump there.

Here a jump, there a jump,

Everywhere a jump, jump.

Old MacDonald lost his farm.

Now he is quite po’.

Monthly payments on hundreds of thousands of subprime loans are resetting to higher levels now. We're close to the peak level of resets. Over the next six months, we'll see the impact of the resets on foreclosure rates. With the economy slowing, real estate prices dropping, gas and food prices absorbing more and more of household budgets, and interest rates trending upwards, the prognosis is for more defaults and foreclosures. If that happens, real estate values will drop even more, making even more foreclosures probable. And to make things worse, large numbers of option ARMs will begin to require amortization of the principal of the loans, which will mean more payment increases.

All this, because lenders made two fundamental errors. First, they forgot that loans should be made on the basis of the borrower's ability to repay, not on the value of the collateral. Back in the bad old days when lenders were prudent, this was a serious no-no. Second, many subprime and option ARM loans were made on the assumption that the collateral--real estate--would always increase in value, allowing a troubled borrower to refinance or sell in the case of default. That they were wrong is now obvious. The downturn in real estate values illustrates why a lender should never make a loan based on the value of the collateral.

Lenders now face increased regulation. And rightly so. If they lend or invest customers' money in such a disastrous way, a few stern regulatory frowns are in order.

Perhaps more disturbing is all the talk of propping up and reviving the real estate market with public money. In particular, talk inside and outside the Fed about the economy not recovering unless taxpayer funds are provided only makes the government an enabler of all the bad things that mortgage lenders did. You can't build an economy by pumping up asset values. The wealth of nations is derived from production, not asset speculation. Japan, Korea, China and India became players in the world economy through manufacturing, not by pumping up their real estate values. Indeed, when Japan did do that, it got burned in the crash that began in 1989 and didn't end until recently.

There's a fin de siecle feeling in the air. A few people are getting astoundingly wealthy, often through asset speculation. Disparities between the wealthy and everyone else grow. The government resorts to expediency at every turn to maintain social equanimity--we don't just mean subsidies for real estate, but also agricultural price supports, federally subsidized flood plain insurance, and the like. The United States deploys a volunteer military to fight an unpopular war in a distant place (a hundred years ago, it was the Phillipines; today it's Southwest Asia). An unexpected fire from the prairies has produced a presumptive Democratic presidential nominee who is the first African-American to receive such an honor.

A century ago, America lived through unrest of the Gilded Age and the Progressive Era, and emerged the strongest nation in the world, one that put an end to the enormously destructive European war called World War I and World War II (which really were one war). But America then was a manufacturing nation, which furnished the resources to quell the fighting in Europe. Today, with its asset-based economy and gargantuan foreign debt, America is in a much more precarious position. So as mortgage resets further batter our economy, we should consider that we didn't get here simply because some lenders allowed their standards to slip. We got here because we want to have things without working for them. And that's not a prescription for prosperity.

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