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   ARTICLE   |   From Scotsman Guide Residential Edition   |   October 2007

Wanted: Smarter Interest Rates

Maybe the Fed — not brokers — is to blame for nonprime’s problems

There’s been no shortage of finger-pointing during the current nonprime–loan crisis. Congress, the Federal Reserve System and the media often are looking for someone to blame, and their fingers often point to nonprime-mortgage originators.

But faulting brokers — or worse, completely abolishing the nonprime market — may not be the appropriate actions in this situation. For almost 20 years, nonprime loans and their originators have been a great help to millions of borrowers, especially this country’s low-income population. Jumping to conclusions could further hurt this ultimately beneficial section of the industry.

To help save the nonprime sector, we need to stop assuming that brokers are the sole source of blame for high default rates. Instead, it’s time to examine the function interest rates play in this equation and the organization charged with controlling them: the Federal Reserve Board.

Adjustable-rate nonprime mortgages are structured so that borrowers who do not qualify for A-paper loans could get a loan with a short-term rate close to that of A-paper, usually for two to three years.

After this period, these rates would increase. For example, if a borrower who earns $4,165 a month with a 55-percent debt-to-income ratio starts with a $2,291 monthly payment on a $500,000 mortgage, the first adjustment would set the payment to 3,844. Six months later, it could adjust again to $4,204 — already exceeding the borrower’s monthly income.

If most borrowers were made aware of these terms at closing, however, why are so many still defaulting when their interest rates increase?

Some people would say that this problem is inherent to the nonprime sector. But the nonprime products have worked the same way since their creation in the 1980s, and they have not been a major national concern until now.

It’s possible that the real problem is not these products but instead, the Fed and its policies. In a typical interest-rate cycle, yields increase quickly for a short term and then drop slowly in a few years.

This is not the case for the current cycle, however. The Fed has kept short-term rates high for more than three years, which hasn’t given many borrowers a fair chance to restructure their loans. The added shock of growing interest rates can lead borrowers to default — without aid from any fraudulent activities from brokers.

In 2004, then-Fed Chairman Alan Greenspan started raising interest rates to slow the housing boom. Since Ben Bernanke took over the position in 2006, he has kept interest rates high to hold the line on inflation.

Although home values were increasing at an alarming rate in recent years, it’s possible that this was not a result of monetary inflation but instead a problem of supply and demand.

If Greenspan and the had not hiked interest rates, in favor of allowing the boom to run its course, it could have led to more building. Under these circumstances, eventually the market would have flooded, and prices would come down on their own.

Change can happen in the nonprime sector if the Fed stops this practice of using the interest rate as its means of controlling the money supply. Raising the short-term interest rate has hurt borrowers who are already facing higher mortgage payments as their rates adjust.

Instead, the Fed should return to setting the discount rate by determining the amount of money needed in the economy and then releasing that amount at competitive bid. Keeping the money supply in control will keep inflation in check, and it will allow market forces to determine interest rates.

Congress can help with this process by putting a short-term restriction on the speed at which adjustable-rate nonprime loans are adjusting. This might involve payment caps, interest-rate caps or new rate-change caps. If borrowers’ payments slow down through this government intervention, it’s possible that fewer homeowners will face foreclosure.

Brokers can help affect these changes by voicing their opinions to their state legislators or mortgage-broker trade associations.

Ultimately, the nonprime-mortgage industry has made homeownership a possibility for millions of Americans by allowing them to borrow money on the short end of the yield curve. But if the Fed keeps the short end of the yield curve too high, as it has during the past few years, nonprime loan-products lose their advantage.

Nonprime loans are too important an element in achieving the American dream to be discarded. It’s possible that they can stick around — if the Fed plays along. 


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