Saturday, March 22, 2008

Homeowner Bailouts?

It had to happen sooner or later. Legislation has been introduced in the US House and Senate that would provide a method of relief for financially troubled homeowners. What seems to have pushed this forward now is the recent "bailout" of Bear Sterns. Comments being made by politicians are along the line of 'if we can provide $30bb to bailout Wall Street, we can surely provide something for homeowners'. But, like many political analogies it does not stand up to scrutiny.

First, if you owned Bear stock I doubt you feel the government bailed you out. You will get $2 for you stock that was trading at $160 last year and $60 just days before the "bailout". Even the $30bb may not ultimately be a cost to the tax payers as it is in the form of a loan. Second, and most importantly, the real bailout was our financial system. Bear was facing a run and would certainly have had to tell clients they could not get to their funds and would have had to declare bankruptcy. We just could not take the risk that this could have led to runs on other investment banks and even commercial banks. Remember, it was not the stock market crash of October 1929 that caused the Great Depression, it was a series of runs on banks in 1930 and 1931 that was the culprit.

Now let's look at the legislation being proposed for homeowners. The federal government would create a fund to purchase mortgages from lenders at an amount equal to 85% of the homes's current value. The lender would then make a new loan to the borrower on terms reflecting the homes reduced value. That seems reasonable on the surface but lets look at how it may look in reality in your heighborhood. (Kind of like the econonist who retorted, sure that's the way it works in reality, but will it work in theory?) Let's assume two neighbors each purchased homes in an overheated market it the peak value for $400k each. One took out a loan for the full $400k purchase and the other put $200k down. Today, each house is worth $300k and the neighbor with the $400k loan cannot make the payments after the initial teaser rate expired. Under the proposed terms of the legislation, the over extended neighbor gets his loan re-writen at $300k. Having nothing invested in the house he has not suffered a loss. The more conservative neighbor, on the other hand, has suffered a $100k loss. How long to you think it would take for someone in this circumstance to demand that their loss be covered as well. This becomes a clear example what is called a moral hazard, or rewarding the wrong behavior. I just don't see how this sort of bailout can fly.


Darren Hom said...

I agree with your assessment of the moral hazard involved in government bailouts. It's good to see people going against the crowd on this one.

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