Countering the Mortgage Bailout: Ethically, Philosophically, and Economically

If you listen to most defenders of the President's $275 billion bailout of troubled mortgage borrowers it is a "yeah but" argument. Yes, we may be bailing out those that overbought, but we need to do it to stabilize housing. Yes, this maybe rewarding bad behavior, but everyone suffers from mass foreclosures. Yes, many of these borrowers likely lied to get a loan in the first place, but our banking system requires that these toxic loans be replaced. It's a sort of desperate times call for desperate action argument. For an example, here is how two leading Democrats put it.

Rep. Bruce Braley (D-Iowa), who founded the House Populist Caucus, says the president has actually gone “to great lengths” not to reward people who have been irresponsible, and that the plan is really an effort to stem another wave of foreclosures in order to stabilize the housing market, which would be to everyone’s benefit.

Michigan Gov. Jennifer M. Granholm, also a Democrat, agrees: “This is not directed at those who didn’t play by the rules,” she says. “It’s directed at trying to fix a system so everyone can stay in their homes and so that everyone’s community is not negatively affected by the foreclosures that are popping up all over that neighborhood.”

All of this rhetoric may sound reasonable but in fact, this mortgage bailout fails not only ethically, but philosophically and mostly importantly economically.

Ethically, the President has assured everyone that this plan will only help those that "played by the rules". Not only is this something that all politicians say, but the numbers simply don't add up. President Obama promises to save up to 9 million homeowners. We aren't in this mess because people played by the rules and fell on hard times. We are in this mess because people lied on their applications and simply overbought. To help 9 million borrowers is to help many that overbought. To only help those that fell on hard times is to only help a few hundred thousand. Furthermore, that help would do little to stabilize housing. Now, we can have a philosophical debate on whether or not someone that lost their job or got sick should get a better mortgage, but in fact that debate is moot. This plan will mostly help those that simply overbought. The numbers tell the story.

Philosophically, this bailout creates a moral hazard. It rewards bad behavior. That's just the long and short of it. In order to qualify for a loan modification, the process is nearly the reverse of a regular qualification. You want to show an inability to pay your current mortgage in order to get a better one. If someone gets a mortgage they can't afford and then is rewarded with a better one, that only encourages more people to get mortgages they can't afford.

The most important argument is the economic one. That's because supporters want all of us to forget the ethical and philosophical one because they tell us that we need to swallow them for the greater good. The problem is that there is no greater good. First, there are those that say this is the only way to stabilize housing and thus that is good for everyone. This is very misleading. First, if you are a renter, you want to see housing dropping as it is. Second, stable housing is only good for those looking to sell immediately. If you plan on being in your property for five ten or even twenty years, a housing crash is of little consequence. Rather, what you really want is to reach a bottom as quickly as possible. The only way to do that is to see all of these troubled borrowers dealt with as soon as possible.

Foreclosures do bring down property values but they only bring them down for six to twelve months. So, it is really only those looking to sell right now that are hurt. Plus, for every foreclosure there is a buyer. If the government steps in to save a borrower, there is a real estate investor that is unable to get a property at a cheap value. So, this idea that stemming foreclosures helps everyone is dubious at best and disingenuous at worst.

Finally, there is the argument that banks need this in order to remove all of these toxic assets. All you need to do is look at recent loan modification history to understand how frivolous that argument is.

Many borrowers who received help with mortgage modifications earlier this year tended to re-default on their payments, a top U.S. banking regulator said on Monday, citing recent data.

"The results, I confess, were somewhat surprising, and not in a good way," John Dugan, head of the U.S. Office of the Comptroller of the Currency, said in prepared remarks for a U.S. housing forum.

"Put simply, it shows that over half of mortgage modifications seemed not to be working after six months."

The latest figures on loans that have been modified in the last twelve months show that more than half go into default within six months. To understand how much of a problem this is for the system, one needs to have a perspective on how good a deals these loan modifications are. Borrowers average rates at about 5%. Often, they have their balances reduced. Rates can be as low as one percent. To offer deals that good on a mass scale, banks would need to have re default rates of less than one percent. Fannie/Freddie loans aren't that good and if their default rates pass one percent that becomes a problem. Yet, default rates approach 50 percent on loan modifications. That is an untennable figure. If the default rates came anywhere near that in the President's program, we truly would turn a crisis into a catastrophe. Banks simply can't sustain a mass of loans at 2%, 3%, 4%, and 5% and have half of them default. They aren't making nearly enough on each loan to sustain those default rates.

Furthermore, with default rates anywhere near there, the housing market wouldn't stabilize anyway. We would still have 30%, 40%, or 50% of these nine million homeowners get defaulted. We would just do it with banks carrying the other half at below market rates. That's truly a recipe for economic disaster.