It’s unanimous: Propping up underwater mortgages is a bad idea

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What follows is a more comprehensive re-write of my take on the latest bailout proposals by the Obama Administration. I felt the original write-up was a bit rushed and one-sided. I have tried to outline the objectives of the bailout plans more dispassionately. And I have added some historical references from prior posts to demonstrate the basic merits of the idea.

Clearly the mindset will not change. It’s all bailouts, all the time in the Obama Administration, as it was at the end of the Bush Administration. I want to talk about the most recent bailouts, why they were proposed, what’s wrong with them and why bailouts generally don’t work. My remarks will concentrate on the principal reduction program since this is the newest bit.

Why bailouts won’t work

What should be clear to you as an observer by now is that these bailouts implicitly assume that government can stuff financial institutions full of taxpayer money and in so doing adequately recapitalize them so that they can lend again.

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The thinking is that, these policies, while "deeply unpopular, deeply hard to understand," are necessary to prevent another systemic breakdown and a deflationary spiral.

Also implicit is the assumption that economic weakness depends in large measure on supporting home price values by increasing the supply of credit via bank lending and securitizations. But, as I argued 14 months ago when Barack Obama came to the White House, the financial system is so fundamentally unsound that bailouts are like catching a falling knife. The writedowns that needed to be taken – in the absence of serious house price appreciation – are just too large to be handled quickly via bailouts.

Moreover, it is the demand for credit which is critical here because households are over-indebted and reluctant to take on further debt. While I do believe officialdom can be successful in creating mild but brief cyclical upticks in consumer demand, weak consumer spending will last for years. The secular trend is clearly going to be toward increasing savings and reducing debt.

So bailouts alone cannot address the debt problem which is behind the reduction in credit demand growth. Nor are they likely to be adequate to deal with the scale of unrealized losses on bank balance sheets. For these two reasons alone, bailouts are merely a socialization of bank losses that transfers financial service sector debt to the public sector. Better would be a reduction of financial services debt via default, nationalization, bank seizure and liquidation.

The latest bailout proposals

With that in mind, let’s review the latest bailout plans from the President. They are touted as "Housing Program Enhancements Offer Additional Options for Struggling Homeowners." Here’s what the official press release says (emphasis added):

The program modifications will expand flexibility for mortgage servicers and originators to assist more unemployed homeowners and to help more people who owe more on their mortgage than their home is worth because their local markets saw large declines in home values. These changes will help the Administration meet its goal of stabilizing housing markets by offering a second chance to up to 3 to 4 million struggling homeowners through the end of 2012. Costs will be shared between the private sector and the Federal Government; the Federal cost of these changes will be funded through the $50 billion allocation for housing programs under the Troubled Asset Relief Program (TARP).

Here is the fact sheet on the program (pdf) with a few extra examples.

Basically, what’s happening here is the government is trying to:

  • facilitate mortgage principal reductions for borrowers who ostensibly can afford their current home.
  • induce larger payments to second liens and add moving assistance to facilitate short sales to induce borrowers who cannot afford their current home to move.
  • prevent foreclosure by granting mortgage relief to those who are unemployed and cannot pay their mortgage

All very admirable. And I do like the unemployed homeowner proposal. This is the one most geared to helping borrowers.

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While I was originally writing this post, I knew that I had written a proposal similar to the principal reduction plan in the distant past. I said "Long ago, I might have supported something like this as a means of accelerating the process of house price declines and getting us to market-clearing levels." Now that I have now unearthed my proposal, you can read what I said below:

Help end the pain in housing.  House prices are going to keep going down in 2009.  I am not an advocate of propping them up artificially.  However, I do want the pain to end.  The easiest way to do that is for government to create incentives for lending institutions to accept loan losses.  I would imagine that governments will need to guarantee a capital for loan modification scheme in order to get this sorted.  By that, I mean that lending institutions will modify mortgage loans to a lower principal amount, incurring losses.  In return, the government will use taxpayer money to recapitalize those institutions only when the modifications occur. This would certainly have to be done in conjunction with a comprehensive banking solution that liquidates bankrupt institutions and strips out toxic assets in order to eliminate moral hazard. Again, the devil will be in the details, so should be a key policy issue for 2009.

Top ten economic wishes for 2009, January 2009

What’s wrong with this?

Very similar to what Geithner is proposing on principal reduction, huh? Superficially, yes. However, Obama’s plan is not tied to anything comprehensive. Essentially bankrupt institutions are being been propped up and the toxic assets remain. The Administration does not want house prices to decline to a sustainable level, but to prop them up. The language "goal of stabilizing housing markets" tells you that. 

So, the aims of the Geithner proposal are to perpetuate the status quo ante via renewed house price appreciation and foreclosure prevention. Moreover, it is clear that the principal reduction is more about the banks than the homeowners. In reality this is a another backdoor bailout for the banks camouflaged as support for homeowners. It is a way of recapitalizing banks by having the government pony up for the dodgy assets still on their balance sheets which they have not yet written down.

This principal reduction plan is a very direct transfer of income from you the taxpayer to the bank. After twiddling our thumbs for so long while the banks were outfitted with bailout after bailout of taxpayer money, while they were allowed to repay the TARP money, and while they were allowed to pay huge bonuses, it is unconscionable that we are shovelling more money into these companies. If they are so healthy as to be able to repay TARP, why do we need to buy them off to encourage principal reduction?

This is bad for homeowners 

Why should I pay all of my unemployment check to a bank to pretend and extend, when I could use that money for some other purpose?  It’s just free money for the banks who should have foreclosed on me.

Meanwhile, if the banks actually do foreclose, homeowners often live rent free because the banks themselves are already pretending and extending. As the borrower, I have the option of either paying my unemployment check over to the bank while the government gives the bank bailout money or of waiting until the bank forecloses on a house I can’t afford anyway without making any payment. Which sounds like a better deal?

Again, this is yet another backdoor bank bailout craftily made to appear as a gift to strapped homeowners. A better plan might be to allow homeowners to be foreclosed and rent their property for a period if they lose their job and their mortgage meets certain criteria, the so-called Baker-Samwick proposal. This is truly geared to homeowners and not to recapitalizing banks.

The program creates poor incentives

Propping up house prices and keeping people in homes they cannot afford only makes things worse. Ostensibly, the program funnels borrowers in houses they can’t afford to short sales, while those who still can afford their home are funnelled to principal reduction. However, half of home loan modifications default again.  This is an indication that the program is delaying the inevitable – raising false hopes in borrowers in over their head and filling the banks with mortgage payments they would otherwise not receive.

There has been a lot of hub bub recently about strategic defaults. A recent report by Amherst Mortgage Insight Analyst Laurie Goodman says that these kinds of programs increase the likelihood of default by changing homeowner behaviour.

Borrowers respond to their economic incentives. This has always been the case, be it for refinancing or for defaulting on mortgages that are deeply underwater. Over the past year, however, property values have been largely steady, but the environment has become much more kind to borrowers. There have been foreclosure moratoriums, the emergence of the HAMP modification effort, and the attendant increases of time spent in the delinquency/foreclosure pipeline, as well as a stretching out of the liquidation process in judicial states. As a result, borrowers can stay in their home rent free for a much longer period than was previously the case. However, few of these benefits apply to investor properties. Thus, when we look at the difference pre- and post-HAMP in the behavior of owner-occupied borrowers versus that of non-owner occupants—we find a dramatic difference in performance. Owner-occupied borrowers behave far worse than their non-owner occupied counterparts.

FT Alphaville rightly calls this moral hazard. And it won’t work because the re-default rate is so high. I am not the only one who sees it this way. A lot of finance blogger/columnist types are coming out against this type of thing: Barry Ritholtz, Tim Iacono, Arnold Kling, Caroline Baum. Also see Housing Wire’s "FHA Mortgage Workout Lacks Incentives and Creates Problems: Industry Sources."

Bottom line: The Japanese experience shows us that extending and pretending is a sub-optimal policy solution. That’s the path we’re on. The Obama Administration is clearly choosing to continue the bailout hustle – and that’s how it will stay.

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