Politics & Policy

Flawed Mortgage Fix

Bush cave-in to Democrats on bankers' bailout will accelerate foreclosures.

The last fortnight has seen President George W. Bush cave into Democratic pressure and withdraw his threatened veto of the so-called “foreclosure-prevention” bill — despite the fact that it retains a $4-billion block-grant program for states to buy up foreclosed properties. Congress promptly passed the flawed bill despite heroic efforts by South Carolina Senator Jim DeMint to slow it down and fix it.

President Bush claimed, rightly, that the program is a bailout for bankers not a hand up for homeowners in trouble. It is measure of Bush’s political impotence that he caved on this new government boondoggle, which not only will fail to solve the foreclosure crisis but actually will exacerbate it. As usual, it will be the little guy who loses big.

Banks have been refusing to sell off foreclosed properties at market-clearing prices, which means they are foreclosing on far fewer homes than the status of their loans justifies.

Instead of foreclosing, banks want to keep even non-performing loans on their books as assets at the loan-origination value, which they are allowed to do under current accounting practices. This allows mortgage lenders to keep a warm body in the house taking care of the asset while they continue using overstated balance sheets to mislead stockholders, regulators, and the public about their true financial health.

For all that’s wrong with this situation, it has had the virtue of attenuating the rate of foreclosures. Therefore, unless the government offers to buy up properties under this new program at prices considerably above market-clearing levels (i.e., above prices speculators will pay right now, which banks are refusing), it will not entice the banks to sell off any more properties than they already are.

Clearly, the president was right before he was wrong on this bill: It is a government handout for the banks, not a hand up for homeowners. But it is worse than simply a waste of taxpayers’ money; it will upset the fragile equilibrium that currently prevents a tsunami of foreclosures from washing across America and drowning millions of American homeowners who are in precarious financial condition and upside-down in their homes.

Currently, banks are allowing many delinquent homeowners to remain in their houses as long as they pay their property taxes and keep their homeowners’ insurance policies paid up. This is not ideal but it is a temporary, market-based solution that could give the housing market time to right itself if the government would get out of the way, stop meddling, and force banks to come to grips with their real financial situation in today’s economy without waiting for Uncle Sugar Daddy to bail them out.

The best situation, of course, would be if banks did with homeowners what they do with commercial borrowers all the time when they get in trouble, namely work out the loan by establishing new terms going forward that reflect changed financial/economic circumstances. Both sides take a haircut; both sides avoid a catastrophic loss. No government meddling required.

For political, legal and regulatory reasons too arcane and complex to go into here, banks are currently being prevented from working out mortgages the way rational economics would dictate. And, with the prospect of a government bailout looming, banks have had every incentive to delay and avoid taking steps they actually can take right now to work out these mortgages.” “

For all of the political distortion and regulatory wedges in the market currently that prevent the ideal solution from coming about, banks nevertheless are engaged in an unlovely, second-best arrangement that allows homeowners to remain in their houses. If the market were allowed to work, banks and homeowners eventually would come to terms, making the best of a bad situation, and the housing market would right itself with the minimum amount of damage possible.

Once the Democrats’ banker bailout begins, however, this self-correcting market process will be short circuited, and the situation will get worse, much worse. It is crystal clear what will happen: Banks will accelerate foreclosures in order to take advantage of the government’s handout. By intervening in the market, the government, as usual, is going to make matters a whole lot worse, not better.

– Lawrence A. Hunter is former staff director of the congressional Joint Economic Committee and currently president of the Social Security Institute.

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