Q&A on Recent Financial Market Disruptions

October 5, 2007

Senior Fellow Douglas Elmendorf explains the roots of the crisis surrounding the rising sub-prime mortgage default rate and suggests that a greater financial literacy would be useful to homeowners and prospective homeowners.

“The U.S. economy is in a delicate position now. The Federal Reserve cut the federal funds rate in effort to offset some of the tightening of credit conditions that has developed over the past several months. But as the Fed said in its own statement Tuesday, the uncertainty about the future course of the economy is especially pronounced right now. And there’s some probability that the economy will come right back and continue to grow solidly and some probability the economy will slow more dramatically.

“In addition to the problems, risk of the aggregate economy for a lot of the individual households in this country that will see large increases in their mortgage payments in the next year and a half. Up to two and a half million households will have their mortgage rates reset substantially higher, and whether they can meet those higher mortgage payments is very unclear. Whether they can refinance their mortgages to avoid the higher mort payments is also unclear. And that creates a risk to both the aggregate economy and also to all these individual households, and that’s where the concerns lie now.

“Well, these problems have naturally attracted a good deal of attention as they should from Congress, the Federal Reserve and from the Administration. I think there are some policy steps that have widespread support now and others that are much more controversial. In terms of the ones that have widespread support, I think that members of both parties in both Congress and the Administration want to provide support for local organizations that counsel households on avoiding foreclosure, although there are disagreements about how much effort and money should be devoted to that task.

“There’s also, I think, a widespread sense that we need to improve the information provided to homeowners about mortgages that they will sign up for to reduce the risk of similar problems arising in the future. I think it’s more controversial though, just how much the government should do and how it should do it to help households that are facing foreclosure; that have maybe lost the equity in their house because their house price declined or just don’t have the resources to pay the higher mortgage payments.

“The President had proposed a number of steps using the Federal Housing Administration to help those households. But many Democrats think that those steps do not go far enough and want to do more through the Federal Housing Administration or through Fannie Mae and Freddie Mac to help provide greater assistance to households. I think that will be the crucial subject of debate over the next month.”