Small Matters: Efforts to fix mortgage crisis must protect the savers, too

Posted: October 31, 2011

Let's consider how - fundamentally - financial markets work. A young person wants to buy a house. A retiree lends that person $250,000 in exchange for a promise to pay a certain rate of interest and return some of the principal monthly for a set number of years. This is a mortgage.

There are two sides to the transaction: the debtor and the saver, who is too often forgotten in the rush to bail out debtors. In simple terms, if the debtor doesn't repay some or all of the money owed, the saver loses, dollar for dollar.

Thus, the claim that cutting mortgage rates on existing loans will generate billions of new spending totally ignores the fact that people living off the interest on their savings lose exactly the same amount of spending power. You won't see that mentioned in the policy discussions about what to do about the housing market mess.

Savers rarely make these loans directly to borrowers. It is costly to locate borrowers, to determine their creditworthiness, to monitor the payments and to offset the riskiness of making one single loan that amounts to an "all or nothing" deal. Mitigating these costs is the role of financial institutions, such as banks.

Savers who deposit their money in the bank "invest" in a pool of loans made and monitored by professionals, spreading the cost of losses over many savers - losses will always occur - and keeping operating costs low. This provides a net return to all savers. So, putting your money in a savings account is investing in the pool of loans made by the bank or other financial institution.

We are not happy with the "experts" who were part of the mortgage fiasco. Losses were so large that savers had to be rescued by the Federal Deposit Insurance Corp. (FDIC), and many financial institutions went bust. Congress, of course, believes it has to do something. It wants to lower rates on mortgages, which are legal agreements to pay savers who put up the money. It wants to "write down" mortgages for people who overpaid for the houses, once again destroying the savings of retirees and others.

The Federal Reserve has used its powerful tools to reduce interest rates to the lowest levels ever. The return on savings is so low, there is little reason to save and put money in a bank. Inflation rates are higher than interest rates, so the return on savings is actually negative.

Because we save so little, we borrow trillions of savings from other countries - $500 billion every year just to finance our trade deficit, and more to finance our federal deficit of $1.3 trillion. Some is borrowed to finance the construction of new plants and equipment in our country. Of course, all the interest on foreign borrowing is not paid to U.S. savers.

Our greed led us to reach too far, borrowing money to finance the good life. Some consumers refinanced their homes many times, continually pulling out more of the rising value in their homes, assuming they could refinance at a lower rate in the future.

Money was loaned based on the rising value of home prices, not on the creditworthiness of the borrower. The "experts" failed miserably. Now, millions live in homes for which they paid too much, can't afford to make payments, and can't refinance at lower interest rates because the house is worth less than the mortgage.

In a rush to make money, we built more homes than there are people in America to own or rent them. Few people see the value of a second home, even at bargain prices, so this excess supply hangs over the market, depressing construction activity - and hurting employment - and home prices.

Only two things can fix this situation: Events, such as hurricanes, that reduce the supply of houses on the market. Or population growth, which will eventually use the excess houses we built in 2003-2007.

There is a housing boom in our not too distant future. But that is a slow process, and politicians can't wait for that.

The Fed will buy hundreds of billions of mortgage securities to lower mortgage rates, which already are at record low levels. Another quarter-of-a-point reduction will not help mortgage demand. It surely will hurt savers.

The greedy hurt us all, reducing the value of everyone's house, not just the speculative homes they financed with savers' money.

Let's hope we don't double down on the damage with government policies that produce a dysfunctional mortgage market - bailing out those who made bad decisions, using the incomes of those who did not. Savers are important to our economy. We should be careful not to discourage them.


Bill Dunkelberg is a professor of economics at Temple University and a nationally recognized expert on the small business economy. Contact him at dunk@temple.edu. Read more of his columns at www.philly.com/dunkelberg.

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