Dean Baker
TPMCafé (Talking Points Memo), December 3, 2008

See article on original website

Yes folks, more good news from the folks who bought you payment option ARMS, collaterized debt obligations (CDO), and credit default swaps. The banking industry (at least the folks not yet in jail) has a great plan to make home buying affordable and stabilize house prices.

They propose that the federal government should make it so that everyone can get a 4.5 percent mortgage through Fannie and Freddie's financing. I know it's rude to question the wisdom of the people who didn't see the housing bubble, but let's try to think about this one for a moment.

House prices have historically not been very responsive to interest rates, but let's assume that the drop in interest rates from 5.5 percent to 4.5 percent can raise house prices by an average of 5 percent. That would raise the price of an average home from around $225,000 to around $236,000. (In reality, the boost might mean that prices would not drop by 5 percent.)

That might sound good. But let's think a little bit about the future, after the current crew of bank executives have gotten their fat paychecks and moved on. Let's imagine that it is five years later and today's new homebuyers have decided to sell their house.

Let's further assume that the economy has recovered and inflation and interest rates are at more normal levels. A typical rate on a 30-year mortgage would be above 7 percent if we ignore the extraordinary experience with collapsing bubbles of recent years. So, let's imagine that five years from now mortgage interest rates are once again at 7.0 percent, which is still low by historical standards.

Okay, if a 1.0 percentage point drop in mortgage interest rates led to a 5 percent increase in house prices, then a 2.5 percentage point increase in interest rates should lead to at least a 10 percent drop in house prices. That means that the home for which today's buyer paid $236,000 will sell for about $213,000 when she sells it in five years. Of course, it is entirely plausible that the interest rates could rise back closer to 8 percent where they were through much of the 90s.

As the bankers say, homeownership is the best way to accumulate wealth. I know it's rude to think about the future when you deal with bankers - after all, just think what would have happened if the regulators had thought about the future when they looked at the explosion of subprime ARMs?

Anyhow, it might be useful if folks gave the bankers' latest scheme a little thought before embracing it this time. Anyone want to buy some CDOs?

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.