Why the efforts to rescue the economy may fail

In an attempt to resolve the present credit crisis, the United States government has taken many steps. Since September, it placed Fannie Mae and Freddie Mac, the mortgage giants under conservatorship, taken a majority stake in the American International Group and passed a $700 billion rescue package for the financial sector. The Treasury is injecting $125 billion into the nation’s nine largest banks.

One cannot accuse the government of being a mute spectator. But what everyone wants to know is will these efforts and the rescue plan succeed?

No doubt everyone wants it to succeed. At the heart of the rescue plan is an effort to keep the credit crunch from sending the economy into a tailspin. The economic downturn is going to be much worse if the financial system doesn’t get working again.

Somewhere in all this, one thing seems to be forgotten – the rescue plan and efforts doesn’t directly address the root cause of the crisis: falling home prices. It was the falling home prices that ultimately resulted in the present crisis. According to the National Association of Realtors, home prices are off 12 per cent from their peak and are expected to fall an additional 10 per cent to 15 per cent between now and mid-2009. Much needs to be done to stimulate demand for homes and to reduce mortgage delinquencies and foreclosures.

The steps taken by the government so far does not do anything to stop the spiral in home prices. This is reducing net worth and creating a falloff in consumer spending. To stimulate demand for homes, the federal government could offer low-interest loans to replace 20 per cent of homeowners’ mortgages. It is unlikely that the crisis will be resolved without addressing falling home prices.

Falling home prices leads to an increase in mortgage delinquencies and foreclosure. Many homeowners end up owning more on homes that their current worth. They then default on their mortgage payments causing foreclosures. The rise in foreclosures results in a negative market psychology. It is a vicious cycle.

The supply of homes on the market remains stubbornly high, while demand for those homes remains relatively weak. The $7,500 tax credit passed by Congress in July has failed to jump-start home sales.

Another factor which led to the present crisis is the total breakdown in the integrity of asset valuations. The government efforts do not address this. The government has not yet disclosed the pricing logic on which the US government will purchase bad debt from faltering financial institutions. It now appears that the prices will be determined on a case by case basis.

While some lawmakers want the government to exert influence over private companies in which taxpayer money is invested while some are calling for a ban on lobbying activity, bonuses and perks among the companies that have been bailed out by the government, nobody has suggested taking remedial action to rectify either the impaired status of asset valuation techniques.

Lawmakers are probably aware of the need to revamp asset valuation methodologies but they lack the will and fear the explosive political impact of any efforts that will directly challenge the qualifications of real estate brokers, appraisal specialists, bank managers, certified accountants, project engineers, corporate monitors and financial analysts.

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