Wednesday, February 18, 2009

How Helping 'Homeowners' Makes Things Worse

Obama announced a new plan to help renters (oops, 'homeowners') who cannot afford their mortgages.

There are two types of people who aren't paying their mortgage bills, and it is not simple to separate them. There are those whose incomes are insufficient to make the monthly payment. Then there are current homeowners who are merely underwater, and do not want to pay (mortgages are limited liability, so they can walk away and not owe anything). So the government has some rule, and 30% of people with such mortgages get to basically write down their old mortgages to a new level that make them able and/or willing to pay. There are two problems with this.

First, it directly lowers the value of the bank's assets. We are simultaneously trying to shore up banks. That the government is legislating this implies that banks will have to write down their assets more than they would have otherwise. So, it is directly inconsistent with the Treasury's other objective, to strengthen banks.

Secondly, it generates huge moral hazard. Say 4 million mortgage owners take advantage of this as targeted. Those who where not targeted, will look at what their neighbor did, on a house bought at the same time, and try to figure out how they too can write down their mortgage obligation. A good number will successfully navigate the lame top-down criteria applied, because any cookie-cutter criteria in Washington creates a very simple target to game. This process will put more pressure on housing, because it creates zombie properties as owners figure out if they can get this done, and it creates a new wave of defaults. Thus, previously people who, while underwater on the property or in trouble because of standard vagaries of chance, might have otherwise paid their mortgage. But to do so in this environment is to be a sucker. Many will find this unethical, but many won't. This creates the second wave of mortgage defaults, the opportunists. I imagine there will be incentives on the demand and supply side to play this game.

The most melancholy of human reflections, perhaps, is that on the whole, it is a question whether the benevolence of mankind does more good or harm.

Walter Bagehot


Anonymous said...

Clearly a bad plan, but while

"First, it directly lowers the value of the bank's assets. We are simultaneously trying to shore up banks. That the government is legislating this implies that banks will have to write down their assets more than they would have otherwise."

is no doubt true, it is theoretically possible that the default and walk-away assumptions embedded in the current values of banks' mortgage holdings have resulted in markdowns below the levels that will result from principal and interest reductions offset by government funding and reduced default rates. At least this slender theoretical possibility might exist if the banks' existing markdowns were reasonable.

Anonymous said...

Eric, I agree 99%.

Norman said...

I agree helping 9 million stay in their homes does nothing for the 2.5 million homes currently REO by financial institutions. (and more to come)

Removing 2 million homes from the MLS for Sale market will help everyone including the homeowner currently upsidedown, the homeowner in foreclosure can now sell into a rising market. (The law of Supply/Demand will increase prices as potential buyers will frenzie to buy a home at discount). The fear of not getting in will drive the market back to a more sustainable level/Price.

The Gov thru an RTC should purchase these homes & send the home to the local HUD agencies for rentals & ultimate disposition thru MLS sales.
The RTC could sell 600 billion in long term (30 year) bonds to finance 2 million homes @ 300,000 (app) each. Price could be set at 20% less than the first mortgage. No jumbos, They work themselves out.

When the homes are eventually sold (as the need for housing increases the HUD could place inventory for sale). Prices will be set @ the original first mortgage (collect the 20% discount from purchase).

Any losses after all homes are sold (5-10 years) will be absorbed by the
institutions selling homes to the RTC in proportion to the amount purchased and sold by the individual institutions. This loss will be paid to the bondholders over the remaining years of the bonds. (more easily digested).

Any comments?

Eric Falkenstein said...

I think you you say you will buy houses at the current appraised values, that might be workable, but only if you simply set the floor at the appraised value and let the banks take them or renegotiate (knowing it has a price floor). But politically, this won't sell, because it does not transfer wealth to homeowners directly. If you add that the owner can reduce their mortgages to this value, then all sorts of homes will be downwardly appraised to the lowest common denominator as each agent tries to get the subsidy.