Lower mortgage rates aren't the answer

House prices weak through 2010

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NEW YORK (CNNMoney.com) -- The government finally realizes that it has to address the problems in the housing market. Unfortunately, it seems officials are considering going at it the wrong way.

According to several reports, the Treasury Department is considering a plan to drive down mortgage rates as low as 4.5%. It would do this by purchasing mortgage-backed securities from the now essentially nationalized mortgage financing giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500).

Low rates, the thinking goes, would make mortgage payments more affordable and get home sales moving again.

The plan misses on a few fronts, however.

"The level of mortgage rates is not the main problem in the housing market," said Dean Maki, co-head of U.S. economics research with Barclays Capital.

Low rates might make people want to borrow, but the plan won't inspire banks to start lending again.

"You can't just mandate lower rates - that doesn't work," said Oliver Ireland, a partner in the financial-services practice group with the law firm Morrison & Foerster. "You have to not only encourage rates to go down but more importantly, you have to provide some confidence to lenders that they can sell mortgages."

For what it's worth, this latest development from the Treasury comes on the heels of a similar announcement last week by the Federal Reserve that helped drive down mortgage rates.

The Fed said it would buy up to $500 billion in securities from Fannie, Freddie and Ginnie Mae, the other government-sponsored mortgage financing firms. It will also buy another $100 billion in direct debt issued by those firms.

As a result, the average 30-year fixed-rate mortgage is now 5.58%, according to Bankrate, down from over 6% before the Fed's announcement last week. And there was a more than two-fold increase in mortgage applications last week.

That, of course, is a good sign. And there is no denying that if banks actually start lending more freely to borrowers that are credit-worthy, that will help the housing market.

Still, much of the increase in mortgage application activity was due to refinancing, not applications for new-home purchases - and it's not even clear if the new plan that Treasury is considering will even allow for refinancing at the 4.5% rate.

Refinancing will help many existing homeowners, especially those who actually stayed current on their mortgages and are most deserving of lower rates.

But even if the government's plan doesn't exclude those who want to refinance, that won't solve the bigger issues plaguing housing: an inventory glut, tight credit for new borrowers and consumer fears that housing prices may still be too high and could fall further.

Lower mortgage rates may entice some people who had been waiting on the sidelines to buy a home. But it will be a gradual process. It won't magically cure what is ailing housing, since this real estate bust is much worse than the last major housing crisis in the 1990s, according to Daniel Oppenheim, an analyst who covers homebuilders for Credit Suisse.

"Lower mortgage rates and better affordability may...help to limit the decline in home prices," he wrote in a report earlier this week. "This will be somewhat similar to the improvement that occurred in the early 1990s, although we recognize that current issues are more severe in terms of the overhang of existing homes for sale (and foreclosures on the market), lack of mortgage availability, and overall negative consumer sentiment toward housing."

The inventory glut in particular is a problem that probably can't be solved by lower mortgage rates. For this reason, many economists have argued that the less intervention by the government with the housing market, the better.

"The drop in housing prices is actually a good thing. We need prices to drop to deflate the housing bubble and make homes more affordable," said Dr. Nayantara Hensel, a special consultant to Economists Incorporated, a Washington, D.C.-based consulting firm.

Along those lines, Barclay's Maki argued that time, and not lower rates, is probably the only real solution to the housing mess.

"There's no single initiative that's likely to put a floor on housing prices. The basic problem was a housing boom that proved to be unsustainable. So in many ways, time is the biggest factor that's needed here to clear some of the excess supply of homes on the market," he said.

Hensel added that with the government doing so much to try and stimulate demand for housing, she's concerned foreign investors could grow wary of the nation's ballooning debt levels and dump the dollar in response.

In other words, that the government may not be able to afford continuing to spend on programs aimed at buying mortgage-backed securities without doing more damage to the economy.

"What I would suggest for the government to do is nothing. Almost every day, some new federal policy is unveiled and it has a big price tag on it. Taxpayers are wondering how the government is going to pay for this," she said. "Too many policies have been unveiled too quickly."