Sunday, November 02, 2008

Bailout for homeowners?

A lot of politicians are talking about a bailout for homeowners to match the bailout that is currently underway for the financial sector. This makes me very nervous.

I understand the motivations behind this, particularly when big businesses get a hand out but the little guy who is working hard (and may be losing his job in this recession) doesn't; there's something unseemly and unfair about the asymmetry.

But there are two key differences between the financial sector and struggling homeowners. The first (and most important) is the collateral damage: when the credit market freezes, the entire economy suffers. (See my previous post on "too big to fail.") The economy can tolerate a single institution failing - which is why Lehman and Bear Stearns were allowed to fail . But when this spreads to the industry as a whole, help is required; this is the goal of the rescue package.

And this gets to the other key difference: there are many homeowners who are in homes that they simply cannot afford or never should have bought in the first place. I hate to say this because it is a coldhearted unsympathetic thing to say, but foreclosure is not only the right outcome for these homeowners, it is a necessary precondition for the housing market and banking sectors in particular and the economy in general to recover. Keeping these people in homes that they cannot afford does no favors to anybody. The homeowners will be perpetually on the brink, the banks will continue to hold high-risk high-defaulting mortgages, and we will have done nothing to correct the overall system.

I need to clarify that I do not believe foreclosure is the right thing for all homeowners that is falling behind or underwater. There are legitimate scenarios where I believe that relief for homeowners can be justified, including:
  • Victims of truly fraudulent or predatory lending.
  • Owners who actually put down 20% and had a good record of payments but are struggling due to the economic downturn.
  • Owners who have faced dramatic revisions to ARM rates, far beyond what a "reasonable" person could have expected.
Note that I say relief "can" be justified for these scenarios, not that it "is" justified. My point here is not to advocate for government relief, but rather to say that foreclosure for these sorts of scenarios strikes me as a very undesirable outcome, and if foreclosures can be mitigated through reasonable measures, that seems like a good thing.

In these scenarios, I happen to believe that the best relief is not a government bailout, but rather for the banks which hold the mortgages to renegotiate the terms to something more affordable. The bank should be motivated to do so because losing some money is certainly preferrable to writing off an entire loan, and because selling a foreclosed house in this market is clearly a money loser, and the homeowner is obviously motivated to do this because it keeps them in their house. The government - especially via its bailout - has the opportunity to prod banks here, without mandating specific actions.

On the other hand, it is the homeowners that are only in homes due to overly lax and aggressive lending standards - such as folks who never provided a down payment or who never had the income they claimed to have, and who are not able to reliably make their payments - who I'm afraid simply need to go back to square one. When they are creditworthy to appropriate standards of risk, by all means they should be given loans to buy a house, but not until then.

The problem with solutions such as Obama's proposed blanket ban on foreclosures, though, is that it is indiscriminate: it helps out some truly deserving people, but it also helps forestall foreclosure in many cases where - I'm sorry to say - a very necessary part of the nation's economic healing.