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US elections 2008: Hillary Clinton's plan to solve the subprime mortgage fiasco is the worst proposal to come along in decades

Americans who have paid any attention to the financial news of the past year know that something has gone terribly wrong with subprime mortgages. They may not know why something went wrong, nor even what a subprime mortgage is, but they know that there is trouble in the subprime sector, and that trouble in the subprime sector has led to trouble in the housing market and trouble for the economy generally.

Americans who have paid any attention to the political news of the past year know that the deadlocked race between Barack Obama and Hillary Clinton for the Democratic nomination is a classic match-up of style versus substance (just ask David Brooks). Obama, as we all know, offers inspiration, uplift, perhaps even euphoria for his most devoted followers, but doesn't deliver much in the way of specific policy. Clinton, on the other hand, offers specific, concrete, detailed solutions to the problems facing her country and the world, and she promises to make up with hard work what she lacks in flash.

Given these converging financial and political circumstances, what positions and actions should we expect the Democratic candidates to have taken on the subprime mortgage crisis? Surely, we should expect something like a moving speech about the plight of subprime borrowers from Obama (but nothing more), versus a 12-point plan from Clinton that would actually fix the mess.

In fact, Obama and Clinton both have plans to address the subprime crisis. There are two salient differences between them: Obama's plan is significantly more detailed than Clinton's , and Obama's plan is a reasonable approach to the problem, while Clinton's is quite possibly the worst proposal any major presidential candidate has made in decades.

To see why Clinton's plan is so misguided, let's first put the matter into some perspective. With the term "subprime" having entered everyday parlance denoting some vaguely sinister lending practices, it's easy to forget that subprime loans are an essential means of extending credit to working-class people, thereby greatly enhancing their prospects for owning property and joining the middle class. Bill Clinton and his supporters regularly like to boast of the expansion of homeownership during the Clinton-Gore years, particularly among minorities. But that expansion did not occur by magic: more people are homeowners now than in the past because of financial instruments that extend borrowing privileges down the socioeconomic ladder. Moreover, on the whole, subprime lending is a dramatic success. As of March last year, a full 87% of subprime borrowers were able to meet the obligations of their loans. (That figure is likely somewhat lower now, but still very impressive.)

However, there is a subset of subprime borrowers who cannot meet their mortgage payments and are on the verge of foreclosure or bankruptcy. Typically, these are borrowers who have taken on an adjustable-rate mortgage, or ARM. Here is how an ARM works, and how it can go awry: A prospective borrower is offered a short-term (say, three-year) interest rate on a mortgage significantly lower than what would be offered on an equivalent 30-year fixed interest rate mortgage. Once the period of the initial rate expires, the interest rate is recalculated to meet current market conditions, at which point it frequently spikes and leaves borrowers unable to afford their monthly payments. Too often, though, this second stage of an ARM does not enter prospective borrowers' calculations. They are lured in by the initial low rate, and in some cases misled by unscrupulous brokers who promise that refinancing is an option if the interest rate increases, without bothering to mention that such refinancing is never guaranteed to present more favourable terms to the borrower.

The proportion of borrowers facing financial ruin because of an unwise or fraudulent ARM may be small, but it is large enough to exert a downward pull on the housing market generally - hence it affects all of us - and even absent any self-interest, it entails that a large number of people are really suffering.

Both Democratic candidates agree that something should be done to provide relief. What should it be?

There are two primary factors that determine the monthly payment on a mortgage, the principal balance (ie, what the mortgage is worth), and the interest rate. Hence there are two ways the government can enable struggling borrowers to meet their mortgage obligations, namely by either altering the principal balance or altering the interest rate. The second solution is the more obvious of the two, precisely because it is the adjustable rates of subprime mortgages that have brought about the loan defaults that have saturated recent news. Suppose a borrower can afford an 8% monthly interest rate but not the 10% rate to which his ARM will soon adjust. To ease that borrower's burden, the government can decree that his interest rate will remain fixed at 8%, and so he need not worry about bankruptcy or foreclosure. This approach is the centrepiece of Clinton's plan: a five-year (at minimum) freeze on existing mortgage interest rates.

At first glance, the plan may seem attractive. It unquestionably provides immediate relief to borrowers on the verge of default. The problem is that such an interest rate freeze provides short-term relief to a relatively small number of people at the cost of inflicting longer-term pain on a much larger number of people and risking damage to the broader housing market of indefinite duration. Why is that the case? Because a freeze on existing mortgage interest rates would quickly drive investors out of the housing market. Investors are an easily frightened bunch, and the uncertainty that an interest rate freeze would inject into the housing market would lead the risk-averse among them to move their investments elsewhere. Now, the price of a mortgage-backed security, like any asset, is determined by a supply-demand relationship. With fewer and fewer investors interested in buying mortgage-backed securities, the demand and therefore the price of such securities will fall.

There also happens to be an inversely proportional relationship between the price and the yield (which can be understood as an interest rate) of a mortgage-backed security. Consequently, as the price of mortgage-derived assets falls, the yield will increase. And the ultimate effect will be a massive spike in the interest rates on new mortgages, as much as 8% or more according to Fortune's Jon Birger. So forget about the interests of the investor class: purely from the perspective of the average working man or woman, Clinton's interest rate freeze plan will make the obstacles to financial security and prosperity significantly more difficult to overcome.

But of course, the implications of Clinton's plan extend well beyond the burdens it places on working people. Freezing existing mortgage interest rates will wreak havoc on the housing market as a whole, by eroding the investment base underlying the market and exacerbating the many problems of the housing market beyond anyone's predictive capabilities. What's more, Clinton insists on imposing an interest rate freeze for five full years. It should go without saying that conditions in the housing market are impossible to anticipate that far in advance.

And even putting aside the manifold conceptual problems with the Clinton approach, the practical complications that would be involved in its implementation could strip away even the meagre achievement of giving some borrowers short-term relief. Imagine it is January 2009, and you are an investor buying some assets backed by ARMs. You are buying those assets because you expect the yield to increase, per the structure of ARMs. However, the recently inaugurated President Clinton has pushed through Congress her Mortgage Relief Act of 2009. Suddenly, the increased returns you were expecting, and which were guaranteed by the legally binding agreements to which you are a party, have been nullified by fiat. In that case, would you not go to court to recover your lost capital?

Many investors would do just that. And so the reams upon reams of litigation Clinton's interest rate freeze would provoke could quite possibly forestall any easing of the burdens on homeowners on the brink of losing their homes. Yet the fact that such a proposal had become law could be sufficient to create the uncertainty in the housing market that would drive away investment and drive up new interest rates. In other words, the Clinton plan, if enacted, could very well simultaneously bring about the harms attendant upon it without providing any of its benefits.