I'll Give Hank This - He's Nimble

Once again, I had intended today to address President-elect Obama's cabinet picks, but Hank Paulson's keeping me busy. The former All-American offensive lineman for Dartmouth must have been one heck of a lead blocker in his day, given his ability to reverse direction.

Not long ago, Hank said he wouldn't be asking Congress for the second $350 billion tranche of the TARP money. Now, apparently he's considering doing just that. For what, you may ask?

Apparently encouraged by the surge of mortgage applications last week after rates fell more than a half-point, Hank wants to subsidize mortgage rates through Fannie and Freddie to bring rates down to 4.50%, effectively returning us to the days before the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA).

Prior to DIDMCA, savings and mortgage rates were fixed. Then came the hyperinflation of the 1970s, brought on by one oil shock after another. So President Carter appointed Paul Volcker, a monetarist, to chair the Fed. Prior to Volcker, the Fed had primarily used the money supply as its primary policy tool. Volcker changed that, using the Fed funds target and the discount rate to shape policy.

To combat inflation, Volcker jacked up the Funds target into the high teens. Using interest rates in this way wreaked havoc on fixed savings and lending rates, so DIDMCA was passed, to allow those rates to float freely. One result of that was the S&L crisis, but it was the right move; we just exacerbated that crisis with one government invervention bungle after another, rather than just letting the free market work its Darwinian magic (sound familiar?).

So now Hank wants to fix mortgage rates at 4.50%, figuring that will solve the housing crisis once and for all by making mortgages more affordable. First, if this fix could really solve the housing crisis, why didn't Hank and Ben do it last spring, when they first reluctantly acknowledged that there was a crisis?

And second, does anyone really think it'll work? Not me.

The problem with housing is not affordability, it's simple supply and demand, those oft-overlooked but omnipresent forces that shape all things economic. I'll say this slowly, in case anyone in Washington is reading these words:

The ... problem ... is ... that ... we ... built ... way ... too ... many ... houses.

Given projected demographic and immigration trends at the beginning of this decade - both of which can be reliably predicted - we needed to build on the order of 1.5-1.6 million new homes a year throughout the decade. Housing starts were above that trend from 2002 to 2006, reaching as high as 2.3 million, and averaging about 1.9 million.

The result? An oversupply of housing stock on the order of about 1.7 million homes by the end of 2006. In other words, builders could have sat completely idle for an entire year before supply and demand returned to equilibrium.

Of course, they haven't, though they've slowed the pace considerably. But that slower pace has only served to work off a little less than half the glut thus far, which is why home prices keep falling. Add to that the huge increase in foreclosures, resulting in empty houses, and you begin to understand why we are where we are today.

Lower mortgage rates will not entice buyers into a market where home prices continue to fall. And the most recent price data suggest a re-acceleration of the pace of decline in home prices. By some reports, houses are undervalued in certain markets. But those markets aren't the problem. In the worst bubble areas, home prices still have further to fall.

The only way to entice people into those homes is to provide an incentive for people who couldn't otherwise afford a home - in other words, couldn't qualify for a mortgage at any rate of interest other than zero - to buy. The way to do that is to relax lending standards.

Again - sound familiar? That's how the bubble was formed in the first place. Lending standards have now returned to sanity, and there they should stay. We cannot afford another asset bubble of any kind in this economy.

Now, one could argue that lower rates mean more people facing foreclosure can afford to refinance. Again, lending standards come into play. The only thing lower rates will do is help those with good credit to be able to refinance into a lower-cost mortgage - folks like you and me, who bought no more house than they could afford, put up a reasonable down payment, and pay our bills on time.

We're not the problem. We're not facing foreclosure. And those that are cannot - and should not - be able to qualify for a mortgage. Besides, even if they get a new loan at a lower rate, said loan should be no more than the value of the home it's financing. Given the number of homes whose value is lower than the current mortgage balance, that won't fix the problem; you can't pay off the original mortgage with the refi.

Unfortunately, what's called for is a draconian and Darwinian response: let the people who can't afford to be homeowners stop being homeowners through the sadly painful foreclosure process. Shoe-horning those people into homes they couldn't afford to begin with sounded like a noble cause when the Barney Franks of the world pushed it back in the mid-'90s, but it was a gross disservice to those poor folks now facing eviction. And to the US taxpayer and the poor saps who bought the crap bonds backed by those loans.