Notes on Policy Responses to the Subprime Mortgage Unraveling

Douglas W. Elmendorf
Douglas W. Elmendorf Former Brookings Expert, Dean - Harvard Kennedy School

September 21, 2007

In recent months, rising delinquencies and foreclosures of subprime mortgages have caused turmoil in broader financial markets, raised fears that many subprime borrowers could lose their homes, and led economic forecasters to boost the estimated odds of a recession next year. These economic and financial developments raise five broad policy questions:

  • What should monetary policy do now?
  • What should monetary policy have done differently in the past several years?
  • What should be done to help households facing foreclosure?
  • What should be changed in the regulation of mortgage lending?
  • What should be changed in the regulation of financial institutions more generally?

These notes offer my answers to these questions. My goal is not to be original, but rather to present a compilation and critical appraisal of many ideas that have been discussed by analysts in the past few months. To preview, I conclude:

  • The Federal Reserve should reduce, but not slash, the federal funds rate, unless stronger evidence emerges of a freezing-up in credit markets or a significant slowing in overall economic activity.
  • Monetary policy should have been slightly less expansionary in 2004 and 2005, but this would not have materially altered recent events.
  • The government should help struggling households to refinance their mortgages, but this help should be reasonably narrowly targeted and should avoid harming the mortgage market and other financial markets in the long run.
  • The government should place greater restrictions on the mortgages offered to riskier borrowers, but it should try not to dampen financial innovation generally.
  • Federal banking supervision does not need to be extended to all mortgage lenders. However, the government should strengthen its oversight of credit rating agencies.