The B-word: Is a mortgage interest rate freeze a government bailout?

by Patrice Sarath, December 11th, 2007, 7:00 am

If so, who exactly is getting bailed out here?

The solution du jour to the subprime mortgage crisis is to freeze those introductory rates so borrowers won’t be hit with a huge monthly payment when their ARMs reset. The move does a couple of things: It slows down the default rate which has been staggering in recent months. Borrowers who qualify (and this is important, as not every subprime borrower would) could maintain their mortgage payments and not lose their homes or their investments.

For lenders, whether they be banks or mortgage companies, the freeze will ensure a continuing flow of income from their mortgage lending operations. The amount will be less than planned, since those higher rates won’t have kicked in, but at least they won’t be hit with defaults and foreclosures. Banks really don’t want to foreclose on houses since they get stuck with real estate they then have to unload in a down market.

For hedge funds and investment banks, the deal is not so good — they invested heavily in those high-risk loans in the form of CDOs and other exotic investments. Freeze the rates, keep those high payments from coming due, and they might as well have invested in stodgy old regular mortgages taken out by people with solid credit. You know, like banks used to do.

As always, the plan, which involves lenders, borrowers, and Federal regulators, has detractors. Some say that the proposal coming out of the Bush White House will not help out the borrowers who were hurt the hardest, nor will it punish (yes, punish) the lenders for their irresponsible actions. For an interesting online conversation on the rate freeze, I suggest taking a look at a discussion on The Perfect World (yes, that’s the name) about its pros and cons.

What it will do is soften the blow for the economy, which otherwise is facing a rude awakening. Now maybe we should let the law of natural consequences take its course, and allow lenders and borrowers who were involved in this folly get what they deserve. The problem as I see it is that their punishment takes out a lot of innocent bystanders as well. Real estate, banking, and construction are an enormous part of the economic landscape.  If they go, we might all go with them.