On Bailouts, In General and Particular
It is, quite simply, wrong for government to bail out homeowners who are facing foreclosure in the tough credit markets that have followed the subprime meltdown. Inhumane? Perhaps…it’s gut-wrenching to watch people lose their homes. But if the market for mortgages is to have any meaning, the notion of ‘risk’ must be matched with ‘reward’.
A mortgage is a loan. People often say they have no debt even when they have a mortgage – a preposterous notion. If you have a mortgage, you owe a debt by definition. A bank or financial institution has loaned you the money to purchase your home – with the home itself as collateral.
The mortgage market has developed categories of borrowers to match the relative risk of default of each. There are ‘prime’ borrowers with excellent credit, alt-A borrowers with average credit, and subprime borrowers who have below average or poor credit. At each level down the rung, a correspondingly higher interest rate is charged to offset the increased risk of the loan.
And loaning money IS a risk – even with the collateral of a home. But if you take that collateral away from the lender, as a government bailout or freeze on foreclosures would do, you have upset the whole applecart. The risk and reward (the reward on any loan being the interest paid to the lender on one side, and the funds to the borrower on the other) are out of whack. You have an inefficient market. What’s so bad about inefficient markets? Well, by definition, they encourage inefficiency.
It’s not only a punishment to the homeowner who got in over his head with a crazy interest-only mortgage when foreclosure happens – it’s also the banks who have to enter the proceedings to get their collateral back. Foreclosure is a messy, costly business – but at least part of the loaned funds can be recovered. Truth be told, banks would just as soon everyone make their payments and avoid the whole sorry spectacle.
But mistakes were made on both sides – lenders were too aggressive with ‘trick’ mortgages, and borrowers were very foolish in biting off more house than they could chew. And both sides NEED to suffer, to discourage this inefficient behavior and work the bad debt out of the system. Firms and households that made good decisions will survive – and some of those that didn’t will go under.
If the government prevents foreclosure, it unfairly favors one side of the transaction, and prevents the lenders from making good on their recourse when a mortgage loan goes bad. So what? Who cares about the evil banks?
Well, you should…because if lenders cannot get their money, AND they can’t get their collateral, then interest rates on ALL mortgages will have to rise, and credit will further tighten…because, at the risk of repeating myself, you’ve lowered the reward for the lender and increased the risk…and the lender will therefore demand a higher reward to offset the risk.
It’s all pretty simple – but our eyes are clouded by the suffering that is sometimes involved. It’s very painful to watch someone bear the consequences of poor financial planning, but unfortunately, that’s the breaks. I made some very poor financial choices myself when I was younger, and I’m still under the burden of the mistakes I made, debt-wise. Fortunately, I never lost my home, and I’ve repaired a lot of the damage to my credit, but it’s still cost me a considerable sum that I should never have exposed myself to…yet it’s the very painfulness and slowness of my crawl back up out of the hole I dug that provides the incentive to avoid that recklessness again.
Risk…reward…two easy concepts that should close the door on a government bailout.
Tomorrow, time permitting, I’ll consider whether Bear Sterns and other corporations should benefit from a double standard…
UPDATE 12:12 a.m.: Just to expand on the above – the bad debt will STILL have to be paid…but by preventing the normal foreclosure process through government intervention, the responsible party is shifted to both (a) taxpayers in general, (b) mortgage borrowers in general, and (c) anyone who invests in any business remotely connected to financial institutions – the taxpayers because they will bear any financial burdens the government takes on, the mortgage borrowers because ALL mortgage borrowing will become more costly to offset any decrease in returns on loans outstanding, and the investors because they will bear the expense of any write-offs…
There are, currently, millions of homes that are “under water” (the outstanding principal on the mortgage is larger than the current market value of the home). From the borrower’s point-of-view, the economically-rational course is “jingle mail” — send the keys back to the lender, and walk away from the house.
If that were to happen, in a significant fraction of cases, it would lead to a meltdown of our financial system.
There are hundreds of billions of dollars worth of mortgage-backed securities, which are now illiquid, because the underlying assets consist, in part, of these now-dubious loans.
As a stopgap, the Fed can assume the risk of those assets (say, by allowing these securities as collateral for loans, as was done in the case of Bear Stearns). But the only way to make the financial system whole again is to deal with the underlying bad loans.
Some will lead to foreclosure. But most can probably be saved, by having the lenders write down the principal (to, say, 90% of current market value) and renegotiate the interest schedule to, say, a fixed-rate loan, at current rates. Imprudent borrowers will suffer a bit. Imprudent lenders will suffer a bit. But the alternative is much too ghastly to contemplate.
Averting disaster, by having the Government step in and oversee an orderly write-down of these bad loans, is far better than closing one’s eyes, and hoping the crisis works itself out on its own.
Slightly higher mortgage rate down the road (which seems to be your main concern) is the least of our worries.
Fargus: I think there are two problems with your argument.
I disagree that “the only way to make the financial system whole again is to deal with the underlying bad loans.” I think the only long-term solution to the problem is to allow home prices to fall to the level of their intrinsic value (i.e., what the home is worth after all of the air has been let out of the bubble.) The government (i.e., the taxpayer) already props up housing prices by allowing tax deductions on mortgage interest. (I’m not sure what is so intrinsically worthwhile about home ownership that taxpayers should subsidize it, but that’s a different issue.) If the government throws billions into rescuing homeowners from foreclosure, it will distort the market further by propping up home prices above where they should be. Moreover, since we are running a deficit, the government has to sell paper to cover the cost of the bail-out, which places more stress on the economy. As painful as the process may be, I think that over the long term the best solution is to let housing prices fall to a sustainable level, at which point to market and economy will strengthen again. Think Schumpeter’s creative destruction of capitalism, applied to homeowners.
The second problem is that “by having the Government step in and oversee an orderly write-down of these bad loans,” the state assumes the tricky role of invalidating a private contract between buyer and seller. People who bought houses with funky terms were consenting adults who knew what they were doing. They made the wrong decision. Why should those who are more prudent be asked to bail out those who are more reckless?
Tell that to Bear Stearns.
First, this is not a “bailout”.
Second, we all (including those who were “more prudent”) stand to suffer (to be precise, suffer more) under the alternative scenario, where nothing is done to prevent a crash.
Third, I’m not “Fargus.”
1) I think the Fed action regarding Bear Stearns was absolutely the right thing to do, and is not comparable in any way to bailing out individual homeowners. First, the action does not necessarily cost anything to the taxpayer – in fact, it may make money for the Fed if the assets are eventually marked up. JPM is responsible for the first billion dollars in losses (if any). The Fed stabilized the market by preventing banks from having to mark to market illiquid securities whose values were uncertain. By providing a backstop – possibly at no hard cost – I think the Fed acted creatively and proactively.
Secondly, it is not a bailout of Bear Stearns (just ask its shareholders). Finally, if Bear Stearns crashed and burned, the effects on the world financial system could be catastrophic (as they were when the much smaller Long Term Capital was the crisis du jour). It seems to me that preventing a global financial collapse is well worth the (perhaps negligible) risk that the Fed took. It is supposed to be the lender of last resorts to banks (and now other financial institutions), and it did what it was created to do.
2) While the plans differ, I don’t see how you can term the use of taxpayer money to subsidize troubled mortgages as anything other than a bailout. Unlike the action with Bear Stearns, if the programs are enacted, there is an absolute certainty of costing a very substantial amount of money. A bail-out is when the ship is sinking and you have to bail out the water. That is clearly the case when the government spends money to rescue homeowners unable to make their mortgage payments.
3) In the short term, homeowners benefit because the government is propping up the market. Shareholders benefit because the market will rally. However, in the long term, the problem becomes worse because it is simply deferred. All bubbles eventually collapse, whether they are tulips, stocks, or real estate. When the government contributes to the bubble, it simply kicks the can down the road for later homeowners and taxpayers to deal with.
4) Whoops: didn’t mean to confuse you with Fargus. Or put words in his mouth.
Where, in anything that I wrote, did you see me proposing that?
I beg to differ.
The Fed opened the Discount Window (for the first time in history) to non-bank institutions (which are not subject at all to its regulatory control). And it accepted as collateral for those loans, worthless securities. (Some of those securities are currently simply illiquid; they will, in fact become worthless if the underlying mortgage loans default, which is what you are proposing to allow to happen.)
There are 3 scenarios here:
1) The mortgage loans default, and the Fed gets stuck with a pile of worthless paper.
2) The mortgage loans are written down (something, which I contend requires some federal intervention). Bear makes good on the loans from the Fed. In this case, the Fed comes out even.
3) The mortgage loans are written down. The mortgage-backed securities become marketable again. Bear defaults on its loans. Then and only then does the Fed come out ahead.
But both of scenarios 2) and 3) assume something is done to fix the underlying mortgage loans.
1) When you write that “the Fed can assume the risk of those assets,” you are therefore using “taxpayer money to subsidize troubled mortgages.” If the Fed assumes the risk by guaranteeing the mortgages at par, they are subsidizing them because they are worth less than par. If, on the other hand, the Fed compensates the banks/homeowners for the delta between the face value of the mortgage and what the homes are worth (as I think Clinton is proposing), then you have a subsidy of a different sort.
2) The loans which the Fed accepted as collateral are not worthless. Some are and other aren’t; in any event, they were marked to market in the Fed’s actions. Hence their diminished value is reflected in the Fed’s actions, as well as the possibility that the Fed can end up making money if the marks were set too low. Hence your options 2 and 3 are the only two outcomes, as the loans have already been written down.
Peter wrote:
Umh, no.
What I was referring to was specifically the sort of action that the Fed took in the Bear Stearns case, a move of which you said you approve. Read the full paragraph that I wrote:
You wrote:
Is that really what Clinton is proposing? I must have misunderstood the news reports.
I was suggesting (largely based on the Frank proposal), that mortgage lenders be required to take a bath on loans that are now under water. And homeowners, offered a fixed-rate loan for 90% of the market value of their home, would not be getting off free either.
1) My point is that it is by no means certain that the Fed actions regarding Bear Stearns will require taxpayer money. From today’s Times:
The Fed agreed to lend JPMorgan Chase $29 billion and to hold as collateral what Fed officials estimated were $30 billion worth of mortgage-related assets owned by Bear Stearns. Working together, Fed and Treasury officials were convinced that Bear Stearns was about to go bankrupt and set off a systemic breakdown in financial markets. … No one knows the real value of the assets formerly owned by Bear Stearns that the Fed agreed to take as collateral. Fed officials have said they greatly discounted the value of those assets before agreeing to the $29 billion loan, but they have offered no detail of what those assets actually look like.
http://www.nytimes.com/2008/03/27/business/27paulson.html?_r=1&ref=business&oref=slogin
In other words, as long as the ultimate value of the assets is at least $28 billion (because JPM is on the hook for the first billion), then the Fed makes money. They have $2 billion in wiggle room from their estimate of $30 billion in fair market value. If the ultimate value is less than $28 billion, then the taxpayers pick up the tag. However, nobody knows if the Fed estimated too high or too low. This is in contrast to the plans being circulated to bail out homeowners, which has the certainty of requiring taxpayer money.
2) Hillary’s plan is to establish a $30 billion fund to purchase distressed properties for resale or rent. I’m not familiar with Frank’s plan, but I’m philosophically opposed to the government rewriting private contracts. It’s not the government’s proper role to interfere in binding contracts, and there can be too many unintended consequences (e.g., if the banks are forced to write down the loans, which will cause their capital ratios to shrink – what do you do when the banks start collapsing? Bail them out too?)
Correction: the value of the assets has to be over $29 billion for the Fed to make money. If it is between $28 and $29 billion, the Fed is even (because JPM takes the hit).
These are properties which have already been foreclosed? She’s then, essentially bailing out the lenders, after the fact (by taking these properties off their hands). It would be better, I think, to avoid foreclosure, wherever possible.
Every Bankruptcy proceeding is a case of the Government (in this case, a Bankruptcy Court) rewriting private contracts.
If you prefer a string of bankruptcies (personal and corporate) to a more orderly (and less catastrophic) process, so be it.
But I think this is better for all concerned (most importantly, better for those of us who had no hand in either side of these bad transactions, but will suffer mightily from the side-effects of a meltdown in the mortgage market).
That’s what’s going to happen if nothing is done. The point is to avoid a string of collapses, by making sure those lenders get 90¢ on the dollar.
“The point is to avoid a string of collapses, by making sure those lenders get 90¢ on the dollar.”
I think these decisions ought to be made by the banks, and not by government mandate. There is nothing to prevent a bank from restructuring a loan on its own. If it wants to take ninety cents on the dollar, all it has to do is rewrite the loan. My problem is when the government takes the role of forcing the banks to restructure loans, because the state ought not to interfere in a private contract. (Bankruptcy is different, because one of the parties has already defaulted.) People make bad deals all of the time. I don’t think it is the role of government to rescue them when they are reckless or foolish.
Moreover, I don’t think “it is better for all concerned” for public funds to be used to rectify the excesses of the housing boom, at least over the long term. In the short term, it will be great: property values will stabilize, stock prices will go up, and things will calm down, at least for a while. However, by goosing the market, the government is contributing to recklessness in the future. If people think the Fed will bail them out if things go wrong, they will take on more risk than if they knew that they were solely responsible for their actions. In my view, there is no reason for the taxpayer to subsidize this risk. People should buy a house if they can reasonably expect to carry it, with the understanding that they face the possibility of selling the house into a falling market if things go in an unexpected direction. If people decide to throw caution to the wind and buy anyway – and if things don’t work out – then I don’t think the taxpayer should be the one to clean up the mess.
Jacques, slightly higher interest rates is not a trivial concern when credit is tight and even good borrowers are having difficulty tapping the markets. The Fed’s rate-cutting spree will help some, but at the risk of cratering the already precarious position of the dollar….
Well, then, I think you have failed to understand the nature of the modern mortgage market. In most cases, the loan(s) in question have long-ago been securitized and sold-off to investors. They, not the servicer of the loan, are the ones face the default (or foreclosure) risk.
Yes, the servicer could renegotiate the loan, but they have no particular incentive to do so. And the investors, who purchased little tranches of thousands of loans are in no position to force them to renegotiate.
In fact, you (through your pension fund, or municipality) may be one of the creditors, now staring down this foreclosure risk (perhaps not, given you apparent lack of concern).
Mark wrote:
I’m afraid I don’t understand your argument, Mark.
Interest rates are at historic lows. That’s not the problem. Lenders are not issuing new loans, because they can’t sell them. They can’t sell the loans because the market for mortgage-backed securities has collapsed. The market for mortgage-backed securities has collapsed because of foreclosure crisis, under discussion discussion here.
You think that attempting to resolve the foreclosure crisis will make mortgage loans harder to get?
Huh?
Oh, I agree that interest rates are not the biggest problem at the moment, don’t get me wrong…but you had seemed to pooh-pooh the idea that they were anything to worry about. My only point is that even things that make it marginally more difficult to borrow throw a bigger shadow under current conditions…
Also, my secondary point was that these lower rates have come at the cost of massive rate cuts that have the dollar treading even lower, and it was low enough to begin with…