Tuesday, August 14, 2007

Subprime lending: should we bail homeowners out or not?

I've previously posted about the subprime crisis, where borrowers are defaulting at increased rates, because a) they were offered exotic loans that turned out to be much more expensive than thought when interest rates rose, and b) they went ahead and took those loans. More recently, you may have heard about several hedge funds collapsing because they a) dealt in subprime-related debt and b) they made things worse by using leverage, or borrowed money; this amplifies both your gains and your losses.

Here, I deal with one proposed mechanism for bailing such owners out. This particular program would ensure that borrowers could actually meet the new payments, is financed by issuing municipal bonds (since they are tax free, the interest rate is lower), and aims to be revenue-neutral. Similar programs are rolling out in several states.

However, there are arguments for not bailing people out, or at least exercising great restraint in doing so. If you bail borrowers out, you also bail out the people who lent to them. The lenders keep the profits they've made and indirectly take taxpayer dollars. Worse, because they do, they get the impression that the government will bail them out the next time with corporate welfare. Face it, these folks are rich, and they don't need taxpayer protection. They paid their money and they took their chances.

American Spectator states it thus:

Equally important, a bailout would set an a dangerous precedent. Instead of holding borrowers, lenders, and investors responsible for their actions, the government would be sending the bill for their mistakes to others. Personal accountability is fair and just. It also sends a powerful message: watch what you are doing.

Every time politicians bail out an industry, they encourage more irresponsibility in the future. In this case, everyone in the process -- homeowners, lending institutions, brokerage houses -- would learn that profits are theirs to keep but losses can be palmed off on taxpayers.

Nor would future problems be confined to the homeowners' mortgage market. The federal government has previously bailed out automakers, steel companies, savings and loans, and hedge funds, among many others. We must break this cycle of irresponsibility.

The breakdown of the subprime lending market is going to generate many losers. That's unfortunate. But we should not exacerbate this problem by making it another crisis for taxpayers.

The Spectator article also takes aim at one proposed bailout plan:
Yet Massachusetts Gov. Deval Patrick has led the parade to bail out the subprime market -- by, ironically, issuing more subprime loans. To allow homeowners to refinance, he has proposed a $250 million fund, with $190 million from Fannie Mae, the national mortgage agency backed by the federal government, and $60 million from the Massachusetts Housing Finance Agency, through a new bond issue.

The loan terms -- 30-year, 7.75 percent mortgages for 105 percent of the home's value -- aren't merely generous: they're a bonus for irresponsible financial decision-making.

Government policy should not reward recklessness, yet that's what Gov. Patrick's plan does: subsidizing the overleveraging of an asset that the borrower can't afford or shouldn't be buying. It's an understandable but misguided impulse to help that casts the state in the role of enabler and unconscionably throws gasoline on the flames.

The money would go to the borrowers in the greatest trouble, thus guaranteeing substantial state and federal losses. (The State Senate separately voted to subsidize employers who subsidize home-owning employees.)

There's a perception problem to boot. The Massachusetts plan is a sweet deal for lenders--and Governor Patrick sat on the board of one of the largest subprime lenders in the country while they were issuing these loans that are now going bad. Advancing a plan to ding the taxpayers he is supposed to represent in order to bail out subprime lenders like the one of which he was a director doesn't pass the smell test, let alone the common sense test.

There are, of course, the less savory arguments for not bailing people out. Jonathan Hoenig, writing for Smartmoney, calls bailouts "immoral."

The purpose of government is to protect my rights — end of story. But because there is no such thing as a right to a home, using taxpayer dollars to bail out homeowners or home lender, is an immoral abuse of governmental authority.

This argument is refutable. We do not live in isolation. It's been shown that rental housing, especially if it takes up more than 30% of income, is often linked to poorer health and educational outcomes. Families in rental housing are likelier to be poorer. If it consumes too much of your income, you have less to spend on education, health, and other necessicities. You have less control over your life. Ensuring affordable housing is a matter of the public good. Hoenig, since his wealth could conceivably be used to insulate him, need not care about the public good. But he does live in society with the rest of us ... so he should shut up and pay his taxes.

Of course, affordable housing doesn't necessarily mean ensuring every person has a house. Not everyone can afford a house, and Hoenig is correct that home ownership isn't a right. Providing affordable housing (rental or owned) in a sustainable fashion should be a right, but bailing people out is not the only solution.

And by the way, my personal position at this point is that the bailouts should stand, for now, but that they should only target people who have the ability to repay the full loans. No mass bailouts. And the subprime industry needs some sort of regulation.

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