Sunday, August 19, 2007

no bailouts

I've been alarmed by the various bailout proposals for borrowers facing foreclosure I've been hearing from politicians and some pundits. Paul Krugman moved into truly dangerous territory this week by calling for massive government intervention to rescue borrowers [excerpts from the Economist's View]:

The mechanics ... would need a lot of work, from lawyers as well as financial experts. My guess is that it would involve federal agencies buying mortgages — not the securities conjured up from these mortgages, but the original loans — at a steep discount, then renegotiating the terms.

This sounds like a bailout to me which puts the taxpayer at risk. My suspicion is that most of the borrowers can not pay full amortized 30 year fixed prime rate mortgage on their debt so any work out is going to be a bailout that reduces the principle loan. Additionally, most of these folks would not qualify for prime rate mortgages in the market so either their interest rates should be higher after the workout or they will being subsidized by the taxpayer as the government agencies will have to resell the loans at a discount since the coupon rate on the workout'ed mortgage will be too small to compensate for the future risk.

Krugman's idea is flawed by Senator Dick Durbin has an even worse one [excerpt from Calculated Risk]:

In September, Mr. Durbin, the Democratic whip, plans to propose amendments to the bankruptcy code, in a bill called the Helping Families Avoid Foreclosure Act. It would, among other things, permit writing down loans and stretching out payment terms.

Durbin is proposing that the property is not really collateral on the loan. The lender will not be able to repossess the property if the borrower fails to make payments and will be at the mercy what the bankruptcy court decides. This truly dangerous proposal will essentially make residential mortgages have the properties of unsecured personal loans. The result being that everyone taking out a new will pay higher interest rates to compensate for the risk the lender won't be able to access the collateral and will get their loan devalued by the bankruptcy court. Reckless borrowers who already have mortgages will get rewarded. Their mortgages will get reduced. The rest of us suffer..

I used to worry that Democrats would try to prop up unsustainable housing prices with taxpayer money like Krugman is proposing. Now I think it is more likely they will destroy the housing market by making lending unattractive. It would be years before lenders and investors know what to expect from bankruptcy proceedings under Durbin's proposal. The prudent thing for investors to do would just be to avoid the asset class entirely while the mess sorts itself out. Which means the jumbo market never comes back, which is bad news for California and other markets where conforming loans aren't big enough.

No doubt the response from Durbin, Schumer and Clinton will be to raise the conforming loan limit so the government through Freddie and Fannie can make the taxpayer take on the risk for every mortgage in America and if that goes wrong we are all going to be in world of hurt. All this because some politicians don't think those who were irresponsible and in their greed figured housing markets always go up are going to have to pay for their misdeeds by losing their houses.

It's almost enough to make me think Milton Friedman was right and the government should not interfere in the economy because they are more likely to make things worse instead of better.

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