Smith Faculty Opinion Article

Peter Morici By Dr. Peter Morici, Professor of International Business
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January 24, 2008

Stimulus Package, Interest Cuts Should Help but Crisis Continues

The $150 billion dollar stimulus package announced by the Bush Administration and Democratic leaders, coupled with interest rate cuts implemented by the Federal Reserve, should help avert an economic debacle but the danger of recession continues.

The subprime crisis has created a shortage of business loans and mortgages, and imposed massive losses on U.S. banks. These are sending housing prices down, drain consumer and business spending, and impose the risk of recession.

Major U.S. banks have written down $100 billion in securities backed by defaulting adjustable rate mortgages and other questionable, creative mortgage products. Other losses are expected from auto loans, credit cards and home equity lines of credit—essentially second mortgages. Total U.S. bank losses should equal or exceed $150 billion and just about cancel out the benefits of stimulus package announced by the Administration and Congressional leaders.

Mortgages have been scarce. The bond market has only been willing accept securities backed by Fannie Mae and other federally chartered banks. Generally, these banks lend only to prime borrowers and in amounts less than $417,000. Jumbo loans and loans for purchasers who are less than prime have not been available, and this has been a terrible drag on the housing market.

As part of the stimulus package, this cap will be raised to as much as $625,000—depending on the average price in a metropolitan area. This will help restore the market for jumbo loans but will not completely restore the mortgage market. Loans for more expensive homes and loans for prospective homeowners who are not “prime,” but who are still reasonable credit risks, will remain difficult to obtain.

Interest rate cuts announced earlier this week will also help by making resets on adjustable rate mortgages less painful and by lowering consumer borrowing rates for prime borrowers. However, many homeowners in trouble will remain distressed.

The absence of a bond market to securitize the largest jumbo mortgages and all but the best mortgages under $625,000 remains a serious problem for the housing market. The Treasury and Federal Reserve should take further steps to encourage banks to reform lending and underwriting practices to restore the confidence of investors in mortgage-backed securities, and in turn, to fully restore the markets for sound, mortgage-backed bonds. Only those steps will return the mortgage and housing industries to normal operations, and ensure full economic recovery.

The stimulus package and recent moves by the Federal Reserve reduce but do not eliminate the risk of recession. Full economic recovery requires fundamental, prompt banking reform.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.