Buy Up the Bad

Posted by Dave Fratello on Wednesday, October 8th, 2008 at 5:06am.

MBC isn't about politics, and your blog author isn't immersed in the presidential campaign, but we'll dip a toe into this for a moment.

That's because Tuesday night's presidential debate saw yet another new idea surface for solving the U.S. housing crisis – you know, the home-price nose-dive that is driving the worldwide financial meltdown. Perhaps you've heard of it. (Obligatory note: Manhattan Beach housing is slow, not crashed.)

Both candidates have previously proposed plans to rescue troubled homeowners. Tuesday night, Sen. John McCain referenced his new idea 3 times. In its first iteration (transcript via CNN):
I would order the Secretary of the Treasury to immediately buy up the bad home loan mortgages in America and renegotiate at the new value of those homes – at the diminished value of those homes – and let people be able to make those... payments and stay in their homes.

Is it expensive? Yes. But we all know, my friends, until we stabilize home values in America, we're never going to start turning around and creating jobs and fixing our economy.
This is not the textbook conservatism we recall from our college days.

As the senator describes the plan, homeowners are holding onto too much debt, to the point that they're upside-down on their mortgages, so the government needs to step in, buy the loans out, write off/pass along the losses, and give the debtors smaller, more favorable loans.

Nobody loses but the taxpayers.

Well, there are several degrees of moral hazard involved, of course. You set this kind of example, and the hypothetical lenders of the future (some day, someone will again be willing to loan money) will once again feel free to throw caution to the wind. They'll know that their bad choices will be socialized.

Likewise, home buyers and re-financers will always have it in the back of their minds that if they get over-extended, they'll be OK as long as everyone else is doing it. Some day Uncle Sam will chop down the loan balance.

More immediately, a plan like this could actually degrade home values faster. Consider the dynamics.

Individual home sellers, facing a declining market, will generally try for top dollar, but they will capitulate if they think the winds are blowing against them, and reluctantly take a discount. Banks holding foreclosed properties (REOs) will take somewhat lower prices to move the properties off their books. Foreclosures are driving price declines all over America. But banks still have a duty to try to get the best price possible. So homeowners and banks have incentives to keep prices relatively stable.

In its worst form, a plan like we heard Tuesday night would encourage lower and lower home valuations. Homeowners seeking writedowns from the government would have every incentive to push their own home values lower. Their new mortgage balances would depend on it.

The U.S. government would be in a peculiar position, needing to determine home values market by market, with a goal – unstated for now – of ending foreclosures. With all this free money flying around, the government could well go along with lower and lower valuations. A plan intended, in part, to stabilize home prices could well push them further down.

Some may object that we're mischaracterizing Sen. McCain's comments. We don't think so.

Tuesday night he said the government needed to "buy up these bad loans" three times. This is different from his current plan (click for details), which narrowly targets fully qualified home buyers who took out sub-prime mortgages after 2005 but can't pay them now. (A universe that seems pretty small.)

The senator's pre-debate plan called for lenders to forgive some principal in exchange for government (FHA) backing of the loans. That's quite different from the Secretary of the Treasury buying bad mortgages, wiping out the excess value and refinancing them. And the new plan is all the more plausible in light of the recent government takeover/conservatorship of Fannie Mae and Freddie Mac. (For a completely different take on what to do with the new government monopoly on mortgages, see this Wall Street Journal oped.)

To be fair, the other senator in this campaign has proposed a fairly noxious plan to deal with bad mortgages held by uncautious or underwater homeowners. The cornerstone is to allow judges to chop principal off the mortgages held by people who declare bankruptcy, and to otherwise adjust the required payments.

Banking interests have howled that allowing mortgage rewrites during bankruptcy proceedings would add huge new uncertainties to mortgage underwriting – with resultant higher rates and costs for everyone to reflect the added risk. Despite ardent lobbying for this provision in the new Bailout Bill, the concept was killed.

Sen. Obama agreed Tuesday night that "we've got to stabilize housing prices." And he said "we're going to have to help ordinary families be able to stay in their homes, make sure that they can pay their bills."

That sounds pretty similar, in broad scope, to the McCain "buy up the bad loans" proposal. Whatever it takes to keep people in the homes they are in now seems worthwhile, regardless of how they got there or how much they took out of the home ATM.

Intervening to prevent market forces from having their way with home prices has a great appeal, at least in the final 4 weeks before an election. But does anyone pushing these ideas really think the declines can be halted?
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