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Subprime Policy Much still depends on policymakers. Their response to the subprime shock has grown bolder and more effective, but it has not yet proved able to stop the fallout from the subprime crisis. A prudent approach dictates that policymakers plan as if their efforts will be insufficient to the task ahead because there were reasons to believe they won't be. The Federal Reserve's dramatic interest-rate deductions in early 2008 were less than effective because the principal near-term link between monetary policy and the broader economy is the housing and mortgage markets, and those are not functioning normally. Housing is the part of the economy most sensitive to rate changes, but lower rates will not jump start home sales if mortgage credit remains largely unavailable. Further rate cuts seem unlikely because of mounting inflation concerns amid sharply rising energy and food prices. The Fed's new credit facilities and its willingness to help resolve the Bear Stearns collapse has improved the financial system's functioning, but these measures have also stretched the central bank's mandate. The Bear Stearns affair sparked particular criticism from analysts who warn that investors will expect the same treatment in future crises. That danger still seems small compared with the disaster that might have followed an actual collapse of Bear Stearns; still, such concerns have reduced the Fed's latitude in responding to the subprime shock. The tax rebates mailed in the summer of 2008 as part of the fiscal stimulus package will also prove less potent than expected because of record gasoline prices. Every penny increase in the price of a gallon costs American households just over $1 billion in extra annual spending. With average national gas prices rising from $3 a gallon at the beginning of 2008 to over $4 by mid-year, the nation's annual gas bill rose by more than $100 billion: just about the amount of the tax rebates. Although the rebate money comes all at once and the extra gasoline costs will stretch over a year, it is clear the rebates won't provide quite the economic pop for which Congress had hoped. Moreover, what happens in 2009 after the rebates are spent if credit markets and the banking system fail to stabilize and the economy is still sputtering? Any hope that financial markets will repair themselves with the help of the Fed and the Treasury Department may prove overly optimistic. Parts of the financial system are in serious disrepair: The private mortgage securities market, for example, is in shambles. The originate-to-distribute model propelled the housing and mortgage frenzy is bankrupt. Even if home prices and foreclosures stabilize, investors will not purchase a private mortgage security without clear guarantees that the mortgage loans behind it are properly underwritten and that the underwriter has some financial stake in the loan's performance. This seems a long way off. Policies to promote work-outs between mortgage lenders and troubled borrowers, such as Hope Now and Project Lifeline, are also being overwhelmed by the magnitude of the problem and the shifting forces behind it. When these programs were established in late 2007, the main driver of foreclosures seemed to be the prospect of huge interest- rate resets on subprime ARM loans. Yet this possibility faded as the Fed's aggressive rate cuts drove down current interest rates, so that by the time their reset clocks ran out in early 2008, many subprime homeowners ended up facing no big jump in payments at all. Foreclosures have continued to increase, but now the biggest problems are negative homeowners' equity and rising unemployment. Hope Now was not designed to tackle these issues, and as of mid-2008 there has been no other policy response from Washington. Policymakers have also yet to address the future. This is understandable given the pressing demands of the subprime shock, but it is important that we focus before long on how to avoid the next crisis.
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