Democratic Wings: A taxpayer bailout of reckless borrowers would be unfair to the rest of us who have made prudent financial decisions

December 10, 2007

A taxpayer bailout of reckless borrowers would be unfair to the rest of us who have made prudent financial decisions

From Andy LaPerriere in the Wall Street Journal:

A bailout package would almost certainly reward the least deserving. Those facing the greatest risk of foreclosure -- and presumably those who would get most of the taxpayer aid -- are those who bought a much more expensive house than they could afford, spent the equity of their once-affordable home, or lied about their income to qualify for a loan they otherwise would not have received.

Would there be an asset test, or would people with two brand new cars in the driveway or six-figure stock portfolios qualify? A taxpayer bailout of distressed homeowners would be expensive, unfair to the vast majority of homeowners and renters who have made prudent financial decisions, and set a troubling precedent that would invite reckless behavior in the future. As the housing market continues to deteriorate, the pressure to respond is growing in Washington. A Treasury Department plan -- to work with mortgage servicers to streamline the process for modifying loans for subprime borrowers who can't afford higher monthly payments -- has been in the news the past few days. Yesterday Hillary Clinton announced a plan for a 90-day moratorium on foreclosures and a five-year freeze on mortgage payments for subprime borrowers. It won't be long before demands are made -- including from Wall Street -- for a taxpayer bailout of homeowners facing foreclosure.

A taxpayer bailout of distressed homeowners would be expensive, unfair to the vast majority of homeowners and renters who have made prudent financial decisions, and set a troubling precedent that would invite reckless behavior in the future. What's more, a bailout will not stop the inevitable correction in home prices, and is unlikely to prevent the associated economic repercussions.

The primary argument for a taxpayer bailout is based on a myth -- that subprime borrowers are falling behind on their mortgages because interest rates on their adjustable rate mortgages have spiked, making their monthly payments unaffordable. In fact, the vast majority of delinquent subprime borrowers are still paying introductory teaser rates (about 8% on average, a below-market rate for borrowers with checkered credit histories). In other words, for most of these borrowers, their monthly payments have not yet gone up.

It is true that many subprime borrowers were sold a toxic mortgage by unscrupulous mortgage brokers. However, the primary reason for the spike in subprime delinquencies so far is that many subprime borrowers have taken on more debt than they can pay back using any reasonable interest rate.

According to Credit Suisse, the typical subprime mortgage starts at 45% of pre-tax income -- before the rate resets. After the first reset, the mortgage payment generally increases to about 55% of gross income (and can go up from there). Many of these loans can't be restructured or modified; the only way the most distressed subprime borrowers will be able to stay in their homes is if the lender or the taxpayers forgive a significant amount of their mortgage debt.

Since so many borrowers -- and not just subprime borrowers -- would need to receive substantial debt forgiveness to make their mortgages affordable, a bailout fund would be expensive, likely costing taxpayers hundreds of billions of dollars. At a time when Congress should be trying to confront the trillions of dollars in unfunded Social Security and Medicare obligations, a mortgage bailout would be fiscally irresponsible.

An important factor that would magnify the cost of a bailout is that it's difficult to know in advance who will default on their loans, and therefore to whom the aid should be targeted. By what standard would the government distribute this aid? What would qualify a homeowner as financially distressed? Should a bailout be limited to subprime borrowers, people who, by and large, have a history of not paying their bills on time? Why not extend the taxpayer's largesse to prime borrowers, many of whom also face large payment increases associated with rate resets?

A majority of subprime loans during the past few years have been cash-out refinance loans. Many subprime borrowers have extracted, through cash-out refinancing, much more than they ever put into the house in the form of a down payment. Would they be eligible for a bailout? How about people who chose a "stated income" option, so they didn't have to document their income and lied on their loan applications?

Would a bailout fund be limited to those with certain incomes or home values? Would there be an asset test, or would people with two brand new cars in the driveway or six-figure stock portfolios qualify? What kind of asset test?

It is self-evident that any bailout fund will be complex to administer, as well as arbitrary and unfair. While the plight of many who were caught up in the housing mania is tragic, a bailout package would almost certainly reward the least deserving. Those facing the greatest risk of foreclosure -- and presumably those who would get most of the taxpayer aid -- are those who bought a much more expensive house than they could afford, spent the equity of their once-affordable home, or lied about their income to qualify for a loan they otherwise would not have received.

Ironically, if passed into law, a bailout would come at a time when many investors are urging Federal Reserve Chairman Ben Bernanke to exercise restraint in responding to recent financial market turmoil. They argue that one important reason investors have taken on excessive risk (say, buying risky subprime mortgages with leveraged funds) was the perception that the Fed would step in and cut the fed-funds rate if asset prices fell, as it has done repeatedly during the past two decades. Economists call this moral hazard. Obviously, the federal government would set a troubling precedent and encourage irresponsible behavior in the future by bailing out homeowners (and, indirectly, lenders and investors).

Some say the government did exactly that during the S&L bailout of the 1980s, but that is not true. The bailout was for innocent depositors who were guaranteed protection of their funds under federal law. The managements and investors of the savings and loans that became insolvent were not bailed out. They lost their jobs and their investments.

The argument will be made that, despite the high cost, inherent unfairness, and moral hazard associated with a bailout, allowing a spike in foreclosures will push home prices down and possibly send the economy into a recession. Therefore, Congress should create a taxpayer bailout fund to soften the economic blow from the housing bust.

Theoretically, a timely and well-designed bailout might slow the descent of home prices and mitigate the associated economic fallout -- but one ought to be deeply skeptical of the effectiveness of a proposal that, at root, is designed to repeal the laws of supply and demand. Home prices were driven to unsustainable levels during the housing boom because imprudent loans created artificial demand for housing. It is inevitable that home prices will fall as that artificial demand is withdrawn.

Congress and the Bush administration are in the process of taking measured steps, such as expanding eligibility for FHA loans and working with industry to streamline the process to modify loans, to help distressed borrowers where they can. To be sure, these proposals will have only a modest impact. But policies designed to suspend the laws of economics inevitably produce unintended consequences. Today's housing bust is itself the unintended consequence of an easy Federal Reserve monetary policy designed to cushion the economy from the fallout of the bursting of the tech bubble. Congress should reject a taxpayer bailout.

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December 10, 2007