Housing bailout

Following the emergency packages passed by Congress and the extraordinary measures by the Federal Reserve to support the Financial Services industry, there have been rising frustration by the American public that more is not being done to help defaulting homeowners.

While foreclosures are on the rise, they have barely ticked up in contrast to the +10% sub-prime delinquency rates, partly because mortgage servicers have been overwhelmed and are unable to process the number of foreclosures required to keep up. Even while Countrywide, the US mortgage giant, is shedding jobs in its underwriting department, they're rapidly hiring in their foreclosures department.

Against this backdrop, the question is whether direct government intervention into the US housing market is (a) possible, (b) desireable, and (c) advisable.

(A) IS IT POSSIBLE?

Its certainly possible. Quite plainly, the US Federal Government has the broad powers to potentially do most anything up to and including buying individual homes at whatever market or above-market price they see fit.

The Federal Reserve also has broad emergency powers from standing legislation that, if invoked, could enable them to take on houses as another form of asset on their virtually limitless balance sheet.

Contrary to what some people mistakenly believe, the Federal Reserve doesn't necessarily "create" money so much as it acts as an exchange portal between long-term debts and super-short-term debts (i.e., cash).

In principle, buying houses is not all that different than the Fed's normal open market activities. The Fed buys one kind of asset (government debt) in exchange for issuing another asset, "currency" (either physical or electronic). If the Fed chose to buy other forms of assets, like corporate bonds, home loans, or even homes themselves, it would put them on its balance sheet as an asset and issue currency in exchange.

Less far-fetched would be Congressional legislation that supports loan modification or loan guarantees-subsidies. These would somehow reduce the monthly payment burden on homeowners who are marginally unable to service their mortgages. In effect, this would be a debt restructuring similar to what industrial/commercial corporations do in Chapter 11 when the two parties to the debt agree that the original interest rate is not serviceable and that it is in everyone's best interest to readjust the terms of the agreement.

Whether its the loan holders who eat the loss, under legislative compulsion, or if its the US taxpayers that end up absorbing the loss, is a subtle and highly controversial nuance.

(B) IS IT DESIREABLE?

For any homeowner who's presently facing default and foreclosure, the obvious answer is yes. There are about 5 million US homeowners in this situation. Another 2-3 million may partly benefit from this as the economy worsens and unemployment rises.

For the 27M homeowners who have paid off their homes, and the 48M homeowners who are paying off their loans on-time, the answer is less clear.

There are substantial systemic effects to the delinquency and foreclosure of the 5M homeowners in trouble including the present distress in the Financial Services industry and the potential for continued decline in home prices. Depending on where the homeowner lives, relief from the downward pricing pressure of foreclosed homes hitting the market may marginally outweigh the incremental tax burden that is being taken on. This would certainly be true in the hardest hit coastal markets where declining prices are most clearly related to ARM readjustments.

In areas like Texas where home prices have barely outpaced inflation over the last 8 years, the benefit to existing homeowners would be negligible. Keeping foreclosures off the market would have minimal impact on housing prices since the minor declines are more related to the rise in mortgage interest rates and the weakening growth picture of the general economy. Texas homeowners would likely be made worse off- paying more in present and future taxes and getting little in terms of potential equity-preservation.

For the industrial Midwest, with substantial exposure to auto manufacturing and other waning industrial sectors, the root cause of mortgage delinquencies lie in sector-to-sector shifts of employment. Benefits from mortgage relief would be limited to those directly in the cross-hairs of foreclosure.

Moving from geographic concerns to generational concerns, we again see a series of potential winners and losers.

For the youngest generations, many in college or living in their first apartments with a job after school, there is little net benefit from supporting delinquent home owners. The most obvious issue is the fact that they do not own houses, and pay rent that's marginally tied to the value of the house. More importantly, any incremental costs from homeowner relief will likely be paid substantially through debt issuance which simply defers the cost over a 10+ year time frame. In 10+ years, the younger generation will be moving into their prime earning years and providing the bulk of the tax revenue. If these taxes are used to service or pay down the debt accumulated today, it will mean paying taxes which they did not directly benefit from. Any marginal improvement to the economic conditions today, will be just that- marginal.

For those closest to retirement, accounting for almost half the total US household wealth, a homeowner bailout would be disproportionately positive. Over half of US household wealth comes from home equity, and for the significant median-centered 50% of US households (by wealth or income) home equity can be over 2/3 of total household wealth. Any plan that even temporarily increases or stabilizes home equity would confer benefits to this generation just before they move into their post-earning years. They would in effect get the benefits, but drop off the tax rolls before having to pay the costs.

Finally, for those who are in between, neither near retirement nor starting life, their benefits and costs from a mortgage-relief plan will depend on their particular situation. For first-time homebuyers who now find themselves staring at an early bankruptcy, the benefit is obvious and tangible. For others who find themselves on more stable footing, the prospect of benefits today may outweigh consideration of what the costs will be in 10+ years.

(C) IS IT ADVISABLE?

Advisability and desirability are intertwined subjects- this is not a technical question but a question of values. At stake include questions like:

-What is the responsibility Americans have to each other to help delinquent homeowners?
-Do we want to spread the pain out over many people and many years?
-Should some generations benefit at the expense of others? Some regions?
-How much do we believe in taking personal responsibility for making personal financial decisions?

Depending on your views on these questions, and questions like it, you will suggest that Federal intervention is or is not advisable.

What we can say, irrespective of values, are the potential consequences.

Firstly, support of the housing market, directly or indirectly, will only be temporary. The Federal Government has the capacity to create an extensive safety net to catch falling prices, but without genuine demand from homeowners, constrained supply, and incomes and interest rates to create viable leverage ratios, prices will continue to decline until the point that the market equilibriates. Now in practical terms, the government can likely continue to support prices until the point when nominal home prices rise to match the support point, but from an inflation-adjusted prespective, that would mean holding prices steady when they "should have" been rising to match inflation. The stability would be visible, but not real.

Secondly, re-opening mortgages creates a precedent that will be priced into future mortgage interest rates. The exact magnitude will be difficult to determine at present, but it essentially puts an entirely new cost into the cost of issuing mortgages, and all borrowers hereafter will be forced to pay a premium because of the potential that the terms may be reopened. This will likely fall heaviest on the lowest credit score and most marginal borrowers creating a regressive tax on home ownership. These are some of the segments of the population that are supposed to be helped by Federal intervention, but they will be made worse off in terms of borrowing costs for the future. Again, a trade off between today versus tomorrow.

Thirdly, the total size of resources needed to support home prices will induce meaningful and sizable distortions to the economy. The first distortion was the fact that housing prices rose as far and as fast as they did. This created more consumer spending power than was sustainable and the pullback and unemployment in retail, restaurants, homebuilders, and other consumer-focused sectors is the consequence of building supply ahead of sustainable demand. Using Federal spending power to support home prices and home mortgages will re-direct resources back into the housing sector and may create some soft booms in these consumer sectors. It only delays the inevitable. Again, if this is done carefully, the economy will grow around the dislocation and in nominal terms, it will appear that there was little disruption. In real terms, however, we will see that other sectors, such as the energy and export-sectors will be disproportionately hurt by governmental action.

Fourthly, the total social cost of such a reallocation will likely be paid for by debt and that will create lasting burdens on taxpayers. While raising marginal taxes on the wealthiest and highest earning Americans may partly alleviate the impact for most Americans in the short term, the disproportionate absolute share of revenue coming from the top 5% of earners is likely approaching levels that are functionally unsustainable. Its not necessarily that the American tax system fails to tax the highest earners enough, so much as the American economic system doesn't enable those in the lower to middle classes to earn enough, and therefore contribute a larger share of the total tax revenue. Over time, this and many other claims on the US government will put increasing pressure to broaden the tax base and the only place left for that broadening to go is further down the income scale. Many European-style social systems are supported through significant Federal sales tax costs in addition to income taxes, and those taxes tend to be regressive, not progressive. For example, Canadian GST + PST in Ontario is 15%, double the average American sales tax.

CONCLUDING THOUGHTS

Helping homeowners is a laudible goal, and considered entirely in isolation, few would be so callous as to think it undesireable. Yet the fundamental principle of Federal intervention is concentrated benefits with distributed costs- distributed over geography, time and socioeconomic bracket. When the absolute magnitude of the size of benefits and costs are relatively small, the broader consequences are muted. But the size of benefits and costs are so enormous, on par with the magnitude of the problem, that serious deliberation and a full and fair disclosure of consequences should accompany any policy action.