The Federal Reserve’s Open market Committee announced Wednesday it was lowering the federal funds rate to 1%, it’s lowest level since 2004. Yet mortgage rates rose on the news and continue to rise today. Though, on the surface, this may seem contradictory it exposes a symptom of the larger financial crisis we face. Since seizing Fannie Mae and Freddie Mac and passing the bailout plan, the Federal government has committed hundreds of billions of dollars in an attempt to thaw frozen credit markets and get the economy back on track. Unfortunately, all of that money is essentially borrowed.

Now the Feds are forced to sell billions in government bonds to fund their various bailouts and bank rescues flooding the market with an oversupply and thus driving down bond prices and driving up rates. This has a ripple effect throughout the capital and debt markets and increases the cost of borrowing for Fannie and Freddie. The higher borrowing costs are reflected in higher mortgage rates for consumers.

The bigger problem facing the Federal Reserve is that higher mortgage rates will have the effect of further weakening demand in the housing market. This will further amplify what is at the heart of this whole mess – declining home prices. As mortgage rates rise and home prices decline further, the rate of foreclosure is sure to rise putting even greater strain on banks and credit markets as well as Fannie Mae and Freddie Mac as the value of their assets depreciate and their ability to raise capital becomes more tenuous. To stop this vicious cycle the Fed and the Treasury must find a way to halt, and eventually reverse, the decline in home prices rather than continuing to merely react to each emergency caused by it. So how could they do it?

There have been a lot of proposals floated in recent weeks that aim to shore up the housing market, stop home price decline and prevent foreclosure. Some of these sound bizarre but viewed in the context of this historic financial crisis I’m willing to entertain anything.

One suggestion has been for Fannie and Freddie as well as banks taking part in the government bailout to offer mortgagors the option of a sixty year amortization. This would dramatically lower payments while not reducing the principal owed and provide an incentive to lenders in the form of greater interest income. Others say to allow everyone to refinance to some set fixed rate such as 5.25% that would provide payment stability and offer most borrowers some relief in the form of lower payments.

Still others have called for an outright principal reduction to lower mortgage balances to a point where borrower’s are no longer upside down in their homes. All of these ideas may have some merit but, in my opinion still do not address the root of the problem. We must create demand in the housing market so home prices will stabilize. How might that be done?

With thirty year mortgage rates creeping upward towards 7% for many borrowers, it is time the Feds start using some of the bailout money to back a program that would allow for a dramatically lower interest rate for all home-buyers coupled with a federally backed mortgage insurance plan to allow for lower down payments and longer amortizations. The lower rate, say 5.00% fixed for 40 years, along with a required down payment of 5% offset by a federal mortgage insurance premium of .75% annually but paid monthly would surely bring reluctant buyers back into the market. The increased demand for housing would drive up prices thus creating a win-win for the government in that the value of the bank stocks they now own would rise along with the portfolios of Fannie Mae and Freddie Mac’s mortgage backed securities. Banks, not wanting to miss out, would begin lending again and the resulting competition would increase liquidity in the credit markets and benefit the economy as a whole and reduce the number of foreclosures.

This plan would not be a reward for bad behavior, would not punish homeowners who have paid their mortgages on time and could be easily implemented through the FHA, Fannie Mae and Freddie Mac. Yes, it would be expensive in the short-run. But given the impotent attempts by the Feds to stop this snowballing housing crisis by hoping banks will lend again by throwing more at them are obviously not working. We need a better idea.

For this and more, visit my blog at www.activerain.com/blogs/hpalmer

Hunter Palmer