Risks of a bailout

Besides the moral hazard problems, one the biggest risks of a government bail is huge losses on the loans that go bad. In California and likely other coastal states, the collateral and not be moved without taking a huge hit:

An auction of about 135 foreclosed homes in San Diego Saturday provided more sobering news for mortgage lenders. Ramsey Su, an investor and former real-estate broker who attended, calculated that the high bids for the homes averaged 67% of the prices they fetched when they were last sold, mostly in 2004 or 2005. At a similar auction in San Diego in May, the average was 73%.

That's a loss of a 1/3rd before expenses! I'm highly doubtful Freddie Mac or Fannie Mae models take these kinds of haircuts into pricing risk. The capital markets see the risk and want nothing to do with this mess which why the secondary market for mortgages has shutdown. If the government steps in, taxpayers could be left holding a trillion dollar bag.

rewarding the irresponsible

There's a great deal of rhetoric both from left wing pundits and Democratic presidential candidates about how we need to save over-leveraged borrowers from foreclosure. I could not disagree more and while this may look cold hearted, I don't think it is.

None of these pundits are politicians are concerned renters can be kicked out their home for no reason at all on 30 days notice. This insecurity is considered the natural state of affairs for the second class citizens renters. However, when first class citizen "home owners" who bought their properties on zero down mortgages on loans they never had any hope of affording when the teaser rates expired are in danger of being kicked out their homes these same politicos declare it crisis and start advocating for massive subsidies from the responsible to irresponsible.

I rent and am subject to 30 day tenancy termination. I concluded that housing prices were dangerous overvalued in my area and I did not want to burden of the large mortgage. Renting if you are not comfortable with the size of the mortgage is the fiscally prudent decision. Unfortunately, renting is an inferior option to buying but because I'm prudent person I accepted the drawbacks. In addition to potentially having to find another home at very short notice, my rent can be raised any amount at any time and the level of repair of residence is only what the landlord chooses to provide.

I'm going to be outraged to pay $1 to bail out people who bought and can not their home afford it. I took hit on renting and now Clinton, Edwards, Dodd, etc want me to pay to somebody else's house because they might be kicked out for not being able to make their commitments. Cry me a river.

Democratic Candidates are almost uniformly pro-bailout

I'm most disappointed to see not a single candidate talked about borrower irresponsibility. It's all the fault of the banks and new economic boogie-man, the hedge fund. Biden sounds like he's the only with a clue which I find unsettling since I tend to see Biden as bloviator.

Here's the their answers from the ABC news transcript. Emphasis is mine.

STEPHANOPOULOS: We're running toward the end of the 90 minutes. I have a couple of quick questions, and then a final question.

This is -- this is basically a yes-no question. We've seem all this turmoil in the markets over the last couple of weeks, caused by the credit crunch and the crisis in the mortgage markets.

STEPHANOPOULOS: We saw, on Friday, the Federal Reserve lowered the discount rate for banks. Should they lower rates for everyone else, yes or no?

CLINTON: I'm glad they did what they did. But it can't be just left to a bail-out for the banks. We've got to figure out how we're going to figure out people facing foreclosures.

And I think a number of us have recommendations on that, that do not lend themselves to an easy yes or no.

DODD: Yes, I think it will happen in September. But we also need more liquidity. And they ought to be allowing Fannie and Freddie Mac to put more liquidity in the market.

It has seized up. You can't get a mortgage in America today.

EDWARDS: I agree with that. But we also need a home rescue fund for all the millions of Americans who are worried about losing their homes.

GRAVEL: All I would say is that there's no answer to that question. Just follow the money of the people on this dais and you'll see a response.

(LAUGHTER)

RICHARDSON: This is the Katrina of the mortgage-lending industry.

RICHARDSON: The answer to your question is yes, there has to be more liquidity, more funds in the market. What we need is more transparency between those that are making this business happen.

And what we also need to do is to not appoint officials that are in the industry to regulate that specific industry. The mortgage industry, they've become -- a lot of them -- a bunch of loan sharks.

BIDEN: The answer is yes. But we need, as the governor says, more transparency, particularly with regard to hedge funds and private equity funds. They are the ones that are causing this thing to go under. And there's no transparency, no accountability. We don't know how deep this problem is.

Chris will take care of it in the Banking Committee, and I mean that sincerely.

But we don't know how deep this problem is. But I think it's much deeper. It's almost as deep in terms of dollars, not liability, as the savings and loan crisis.

OBAMA: We do need more liquidity, but we're going to have to not only help home owners who are going to be losing their homes as a consequence of this; we're going to have to go forward and make sure that we've got the kinds of tough regulation when it comes to financial instruments to make sure that people who have saved and are trying to get their own home for the first time are not hoodwinked out of it.

OBAMA: And, unfortunately, the reason that we haven't had tougher regulation in part goes back to the issue of lobbying. This is where special interests have been driving the agenda. We have not had the kinds of consumer protections that are in place.

And that's why, when we have this debate about lobbying, we have to remind ourselves it has very real consequences for the people of Iowa and the people around the country.

(APPLAUSE)

KUCINICH: The answer is no. The Fed is actually looking at bailing out the creditors. And what we're looking at is a continuation of the problem and a postponement of the day of reckoning.

We need to have a government take strong action where we'll loan money to those who are in trouble. But we need to do that in exchange for having the power, the money-lending power that the banks have right now, come back to the government; government spends money into circulation; and then government can maintain control over the economy.

KUCINICH: Unless we take this action, we're looking at a situation of the collapse of our economy, and we're looking at a situation where these hedge funds will try to get a bail-out while millions of Americans lose their homes. Save the American homeowners.

(APPLAUSE)

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.