[OPE] Feldstein on the core US recession risk

From: Jurriaan Bendien (adsl675281@telfort.nl)
Date: Thu May 08 2008 - 10:37:01 EDT

NBER President Martin Feldstein (previously in favour of privatizing US social security or parts thereof) now argues that the federal govt should bail out US home owners in trouble using cheap loans, in return for giving up the right to default on their mortgage. Concurring with Roubini, Feldstein argues that

"... the most serious risk is that the rapid fall in house prices - down more than 12 per cent in the past year and falling at a 25 per cent rate in the past three months - will raise the number of negative-equity mortgages, leading to widespread defaults and foreclosures. Because US mortgages are "no-recourse" loans (lenders have no recourse to the house's owner beyond the value of the house), individuals with negative equity have an incentive to default. There are now an estimated 8m negative-equity mortgages - more than 15 per cent of all outstanding mortgages. Defaults are rising and foreclosures are now at twice the rate of a year ago. A downward spiral in house prices would cause a fall in household wealth and in the capital of financial institutions, potentially resulting in a deeper and longer recession than any seen in the past several decades. (...) What is missing is action to prevent positive-equity mortgages from becoming negative-equity mortgages. The federal government could achieve that by providing low-interest loans with full recourse that would allow any homeowner to pay down a significant fraction of his mortgage. Homeowners would be in effect giving up the potential to default on their mortgage loans in exchange for lower interest costs. Although political tensions make it difficult to achieve such a policy, a mistakenly benign view of first-quarter growth contributes to this stalemate. Policymakers must recognise the real economic condition and act quickly." 


Quite correctly, Feldstein argues the credit crisis is far from over. Assume the average house price is somewhere near $300,000 - then the 8 million negative-equity mortgages must represent an asset base in total worth more than $2 trillion. A 25% fall in value would represent upwards of $0.5 trillion, an amount roughly equal to the average annual increase in US GDP in recent years. Naturally Feldstein lets the sellers of variable-rate mortgages who leveraged the loans off the hook... his own "loan adjustment scheme" however assumes that the intending defaulters have a steady job and a steady income, so that they can continue making their mortgage payments as such. But many subprimers are in fact not in a very stable situation, a large proportion of them (quite possibly close to half) are low-income earners, and if one out of every seven US workers already fears losing their job in the next year, the motivation for entering into a new mortgage contract they cannot get out of at all, is unlikely to be very strong. A more likely scenario is that the number of foreclosures will ratchet up against a rising number of job separations.




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