Sunday, April 13, 2008

Unintended Consequences of the Coming Socialization of the Housing Market

I've argued many times that the best thing, as a nation, despite short term pain - would be for housing prices to fall nationwide to a level that would allow most homeowners to only spend 30-35% or their income on housing costs. [Dec 6: Analysis: What Should Median Housing Prices Be Today?] This would allow people to for example... buy food and heat their homes... without stress of wondering how they'll afford to do it. Or do crazy things like... well, save or invest. By people I mean people not in the upper 10-15%. Heck this would even allow for a huge flow of spending and consumerism which is what our economy is based on. But it would require a shorter term, painful period of adjustment of home prices from their completely out of line (in major urban areas) levels, where "typical people" with "typical jobs" have to resort to financial engineering just to have a roof over their head. When you have a chart like this below, you see bubble-economics at it's best - the market will eventually overwhelm the interference the government is trying to achieve until a true equilibrium is met... when a police officer can afford to buy a home in the city he patrols would be a good measure - you know - like in the 60s, 70s, or 80s. Right now we are trying to build a dam in the price erosion to keep prices inflated at say 2004 or 2005 levels. Not going to work - until people can afford normal homes with normal payment terms with 5-10% down with normal median incomes - we are not done with our little correction...

I found a great article on discussing one major unintended consequence from the coming proposed bailouts - one of many we create by interfering with "free markets" - i.e. ethanol boondoggle, keeping interest rates at 1% for ages, etc. Well we are going to embark on a new era of "solutions" which will create even more problems... again, the best thing would be a quick (albeit painful) readjustment period in housing prices, which would allow people currently renting to afford homes. But the government seems inclined to (attempt to) stem home price deflation by any manner possible... this is socialism at it's best.
  • If I understand its terms right—and I think I do—Barney Frank’s ballyhooed $300 billion plan to stem subprime foreclosures figures to take a bad situation and make it even worse. Reason: the plan would give up-to-date borrowers a powerful incentive go delinquent on their loans, perhaps on a massive scale. This is supposed to help fix the problem?
  • But as it’s written now, here’s how the Frank plan would work. The holder of a delinquent subprime mortgage would take a writedown on the loan, then dispose of its loan in a short sale funded by the issuance of a smaller, government-guaranteed FHA loan. In return, the holder escapes further credit risk. Fine. The specific size of the loan writedown, though, would depend on the size of the new FHA loan, which in turn would be set according to terms “the borrower can reasonably be expected to pay.” In particular, the maximum allowed loan-to-value ratio of the new mortgage would be 90%.
  • As I say, if the government has ever before put in place such a powerful inducement for wholesale borrower delinquency, I can’t recall it. Let’s walk through some numbers and you’ll see what I mean.
  • Take two neighbors, who both took out 0%-down, $300,000 ARMs, each with a 5% introductory rate, in mid-2006. Since then, the houses they bought have fallen by 10% in value, to $270,000. At reset (which will happen any month now, to around 8%) their monthly payment will rise to $2,000 from the current $1,250.
  • OK so far? The only difference between our two borrowers is that Borrower A is current on his loan, while Borrower B is delinquent, and so qualifies for relief under the Frank plan.
  • And, indeed, Mr. B applies for relief. His new, FHA-funded loan comes to just $243,000—90% of his home’s $270,000 appraised value—so his monthly nut (at the same 8% he would’ve been paying under the terms of the old loan) is now just $1,620. Still-current Borrower A, recall, is paying $2,000 per month, after reset, for the identical house. Oh, and Borrower B now has $27,000 of equity in his home, while A is upside down by $30,000.
  • What do you suppose the Borrower As of the country would do at this point? I’ll tell you one thing: a lot of them would go delinquent on their mortgages on purpose, to qualify for the same sweet deal that the Borrower Bs have gotten.
  • You might object at this point, and say that that Congressman Frank has built safeguards into his bill—like, say, insisting on a government claim on any subsequent home-price appreciation--to prevent intentional delinquency from happening. You would be mistaken. Sure, the feds would have a claim on any gains the borrower realizes after a sale. But the size of that claim declines the longer the borrower stays in the house, and falls to zero after year five in any event. In the meantime, the borrower gets an immediate $57,000 boost in his equity, to $27,000 from minus-$30,000.
We are telling every American (currently 1 in 10 homes nationwide, and growing by the day) who is "upside down" on their mortgage (value of home less than they owe) to apply for Mr Frank's program. And then everyone else who plans to stay in their home for at least 5 years and has less than 10% equity? Do the same - you go from sub 10% equity to "10% equity" instantly, and a lower mortgage payment to boot. And the plan still makes sense for those who plan to move in 2,3,4 years - all you need to do is give up some of the "gains" from selling your home to the government (not all of it though!) - which is still more than the "no gain" you would have (since you are underwater!) if you did not go delinquent and get a new government sponsored mortgage. So you go from having to bring money to the table at closing to get out of our mortgage, to getting a windfall - even if you only live in the house 1 year... magic! Talk about incentive to go bad on a mortgage!

Now that I think about it what is to stop people who have more than 10% equity (say 20-25%) to take a 2nd mortgage or a home equity line of credit, take the cash out of the home ATM, and then you too will be under 10% equity - and then can default! The government will quickly come in and give you 10% equity - magic! And you get to keep your cash out which you probably bought a nice SUV or did a kitchen remodel with. Fantastic!

And so once again, by trying to step in and stop the market from going where it will eventually go - we will create moral hazard and unintended consequences left and right. Just about par for the course from this short sighted Nanny state.

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