How Government Makes the Foreclosure Problem Worse

By: Nick Adama

With continuing record foreclosure rates, more people, pundits, and politicians are calling for more direct involvement by the government in the market. Freezing rates, punishing banks, and offering rates as low as 0% to borrowers have been proposed. But holding the banks themselves accountable through government intervention will not serve the overall purpose of convincing banks to begin making prudent lending decisions again. In fact, it was government intervention in lowering interest rates and offering cheap credit that significantly contributed to the real estate bubble to begin with.

Rate freezes and low interest rates

The problem with creating rate freezes or giving extremely low interest rate loans to those with poor credit is that many of the largest banks that would be making these loans are owned by shareholders who are attempting to capitalize on the highest returns and lowest risk that banks can offer. Many of these investors include pension funds, mutual funds, insurance companies, individual investors, and other institutional investors.

If the government got involved and started regulating interest rates and lending programs directly, many of these large investors would take their money out of the financial institutions, looking for better returns in other markets. How happy would any person be if their 401(k) was returning 0% for18 months with a low interest loan with a freeze? Probably not very pleased at all. What if it was returning a negative rate, because collecting 0% interest does not pay for the direct costs banks have when making loans, and profits would have to be taken out of the principal amounts coming in? This would be even worse, because no one wants a negative investment return.

Fewer Foreclosures? Doubtful

Furthermore, these programs would not even prevent foreclosures from occurring. Homeowners fall behind on their loans for a variety of reasons, including job loss, medical illness or disability, and financial mismanagement. Freezing mortgage rates at a low level would not prevent weaknesses in other industries and contributing to job losses if firms close or are shipped overseas. The responsibility having a plan to provide for an emergency and finding solutions to stop foreclosure rest squarely with the homeowners and the banks. If they can not come together to work out plans, the government will have a tough time bridging the gap.

In cases of medical disability or sudden accidents, the high cost of insurance and medical care are directly caused by government intervention in the medical industry. Direct government intervention in the lending industry would cause much the same problems, with banks having to add more up front fees or requiring higher down payments in order to make up losses from artificially low rates that do not eliminate or adequately transfer the risk.

No Financial Education -- Who is in Charge of Schools?

On the other hand, advertising to kids just entering college to pick up a credit card is not a good practice for banks to be engaging in. This just traps them in the credit nightmare at the earliest age possible, and entry-level jobs for high school graduates who are pursuing a college education are not reputed to be the most stable. In addition, many college kids can not afford halfway decent food every day, let alone pay 29% interest rates on a credit card that they use to purchase their $200 school textbooks. Maybe banks should offer students jobs or internships, or colleges could offer more work programs, instead of offering credit cards to the kids the second they leave their parents' house. Arguably, this would be a much more effective manner or creating "brand loyalty."

But is is the government-run public schools that are directly responsible for the lack of financial education being given to the vast majority of kids. Through their first eighteen years of school, students do not learn even the very basics of financial management, from how to balance a checkbook, to the importance of saving up an emergency fund, to the real costs of credit cards, to how to read a simple contract, and so on. If they did have any kind of basic financial education, then, presumably, they would not be such easy targets of lenders.

Government is not Here to Protect You from Yourself

The more government gets involved in any activity of a person's life, the more uninformed people will allow themselves to become, because "government is here to protect us" if they make a mistake. They can simply demand "change" and their representatives will offer them more free bailouts to appease the public and regain election. But government is not there to protect anyone from mistakes caused by their own willingness to remain uneducated, and government is especially bad at protecting people from themselves.

If homeowners enter into a voluntary contract that they say they understand, and sign dozens of papers admitting that they understand what they are reading, but in actuality have no idea what is going on, then it is up to them to speak up and have it explained to them, either by a mortgage broker, real estate agent, or title company representative. If none of them are able to explain the contracts, then it is best to hire an attorney who can explain in plain English what a mortgage means.

Are Banks Learning?

But banks are starting to wise up now, although their reaction has been to deny credit across the board, rather than make more prudent lending decisions. Such success, if it can be called so, is a small step in the right direction (three steps in the wrong direction, one step in the right). So many defaults have wiped out their reserves and now credit card delinquencies are increasing. Citigroup is effectively bankrupt, Countrywide is being eaten up, and over 200 mortgage lenders have stopped making subprime loans or have gone out of business. They learn when they lose money, even if the Fed bails them out with billions of dollars of inflated money (see, there goes government intervention again helping banks avoid the effects of their poor decisions).

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