Assorted thoughts on moral hazard

I am genuinely conflicted by what we should do about moral hazard in the housing markets and the financial markets. Make things too easy, and people will be encouraged to take more insane risks; make them too hard, and the economic results will force the rest of us to pay for their sins.

Whatever it is we do, however, I'm pretty sure we should take the same approach to the homeowners and the bankers. Most homeowners are not dupes of anyone other than their own speculative mania; they borrowed more money than they should have on the assumption that asset prices would just keep rising forever. The bankers, the same.

One thought I have had is that perhaps we should declare a sort of bank holiday for people whose mortgages are unaffordable. Set a three month period during which people can hand the house back to the bank in exchange for canceling the loan and surrendering whatever extra cash they have in the bank. No expensive and time consuming foreclosure procedures; they voluntarily sign it over. In exchange for their doing this, we wipe the loan off their credit record. They don't get to keep a house they can't afford, but they also don't get crippled for the next ten years by an unwise but somewhat understandable urge to own a nice house.

Meanwhile, this is not correct:

Whether the BS bailout will motivate riskier behavior in the future is impossible to know directly. But the market has spoken in one regard: the stock prices of the investment banks that Wolf refers to jumped about 20% after the bailout. The market, obviously, thinks the bailout has made risky behavior less risky and more profitable than before. As Wolf says, this is "moral hazard made visible."

A put option at $2 a share in the event of catastrophic failure is not worth 20% of the current stock price; it is worth considerably less than $2 a share. Stock prices rose because Bear Stearns had been the counterparty to a really staggering number of trades that markets thought would be uncovered, and because fears of an acute liquidity crisis abated. Not because people suddenly no longer feared losing money on the stock.

Comments

Whatever it is we do, however, I'm pretty sure we should take the same approach to the homeowners and the bankers. Most homeowners are not dupes of anyone other than their own speculative mania; they borrowed more money than they should have on the assumption that asset prices would just keep rising forever. The bankers, the same.

Which is why I'm irked by Sen. Obama's commments on Sen. McCain's recent speech. Sen. McCain suggested that the root of the problem that banks lent money to people to buy houses that they couldn't really afford, and that the problem couldn't really be solved without house prices coming down and that some people were going to have to leave unaffordable houses. He also suggested that he opposed bailouts in general, and specifically of both lenders who lent money that couldn't be repaid and of speculators looking to flip houses. Sen. Obama had the predictable response of blasting predatory lenders, wanting to start investigations of same, the magical transformation of ARMs into fixed mortgages, and a "foreclosure prevention fund," because people shouldn't have to "foreclose on their dream." Same old divisive politics from Obama.

Posted by John Thacker | March 26, 2008 7:30 PM

"A put option at $2 a share in the event of catastrophic failure is not worth 20% of the current stock price; it is worth considerably less than $2 a share."

What are you talking about, here? No trader who understood put options would ever refer to a "put option at $2 a share". A put option can trade at $2 or have a strike price of $2, but what you write is what? Are you talking strike price or option price? Also you would need at least these varaibles, strike price and option price to make sense of analysising a situation, and further you would also need the price of the stock.

This is a verrry shaky post.

Posted by Sidney | March 26, 2008 7:32 PM

No expensive and time consuming foreclosure procedures; they voluntarily sign it over. In exchange for their doing this, we wipe the loan off their credit record.

Megan: Great idea. One of the terribler ideas out there is the notion that giving your house back to the bank is the worst fate imaginable, or that it equates to homelessness. But of course it doesn't equate to homelessness. It simply means rejoining the ranks of the renters. Often at a big decrease in one's monthly housing expenditure.

The problem though (and I gather this is why we see things like that widely-reported Hooverville somewhere in California's Inland Empire), is that people in the foreclosure cycle often are pretty broke, and have terrible credit, and so renting an apartment becomes awfully difficult. So, I'd say the emphasis should be not on allowing people to hold onto purchased homes they really can't afford (especially if it costs the taxpayers money, or exacerbates moral hazard, or messes with the property rights of the owners of the IOUs), rather, the emphasis should be on preventing a huge surge in homelessness. And this can be most readily accomplished by making sure the rental market operates efficiently, and perhaps doing something to insure that all that repossessed property doesn't sit empty (and that much or most of it can be rented to people who need shelter).

Posted by Jasper | March 26, 2008 7:46 PM

Sidney, if you trade options, I'm pretty sure you should be able to figure out the implied put in the Bear Stearns deal.

Posted by Megan McArdle | March 26, 2008 7:57 PM

Set a three month period during which people can hand the house back to the bank in exchange for canceling the loan ...
Unless they pulled their own equity out of the house last year and spent the money on vacations and fancy cars.

Posted by Robert Ayers | March 26, 2008 8:05 PM

"The implied put"?

Please enlighten.

Posted by Sidney | March 26, 2008 8:42 PM

Nine decades of moral hazard has created this mess. And what proposals do we see over and over? More moral hazard.

Megan, your proposal is a drop in the bucket, however (which is its best feature, by the way). It will make little difference- the losses are the losses, and making foreclosure quicker isn't really going to change that much. Maybe it would allow realization of the losses to be made more quickly, but this also may mean that many lenders turn out to be completely insolvent sooner.

There is no way out of this mess, and I fear prudent people are going to be made to pay for it directly, which really, really pisses me off since I am one of them.

Posted by Yancey Ward | March 26, 2008 8:43 PM

The right to sell your stock for $2 a share rather than cents on the dollar in bankruptcy?

Posted by Megan McArdle | March 26, 2008 8:59 PM

Megan, just admit it--you have no idea what a "put option" is. I actually know because I used to trade them for a living. You, however,
should admit that you're wrong this time--now--instead of drawing out your wrongness for five years, like you did with the Iraq War.

Second, your idea that people who now have "unaffordable" mortgages should "return" their houses to the bank during a three-month bank holiday is truly idiotic. The worst is that you think that homeowners who are in arrears with mortgage and underwater with the equity in their home have all kinds of "extra cash in the bank." This is beyond moronic--it's blind numbingly stupid. If people had "extra cash" in the bank, they'd pay their mortgage on time.

What planet do you live on. Do you seriously believe that there are all kinds of homeowners who have "unaffordable mortgages" but still have "MONEY IN THE BANK"?

Good God. Think before you write.

Posted by Blake | March 26, 2008 9:27 PM

I'm not wrong, Blake; if the stocks had actually leaped on a moral hazard play, as Kevin argued, the only possible reason that I can see would be that investors thought the implied put hedged the downside risk. The hedge, however, is far too small to explain the stock price movement.

Blake, I agree that they probably don't have money in the bank. If they don't, they can hand back the house. The provision is designed to keep people from stopping their mortgage payments on day one and handing the house back on day 89, which might make it a tad hard to get the lenders on board.

On a final note: I am really. not. kidding. about having a civil comments section. If you wouldn't say it to a stranger in real life, don't say it here, or I will delete your comments and ban your IP address.

Posted by Megan McArdle | March 26, 2008 9:41 PM

Blake,

Clearly the analogy is too complicated for you, so I'll try to explain what Megan clearly means:

The "bailout" means that BS shareholders got $2/share instead of waiting for bankruptcy procedure to (probably) give them even less.

If we assume that a similar deal would be offered to any other bank or bank-like-institution, this is equivalent to all shareholders in those institutions being given a little piece of paper saying "In the event of the company collapsing, you have the right to sell your shares at $2. Luv, the US government."

This can be considered a type of Put option. NO, it is not exactly the same as the usual put option that is traded on the exchanges, but nonetheless, it is a right to sell at a given price, sometime in the future.

Megan's point is, a $2 strike price put option on shares currently selling for $100 is NOT going to result in a 20% price increase.

It seems to me that Blakes response to this is an example of War-derangement-syndrome, where people lose reasoning ability due to blind rage about Iraq.

Posted by doctorpat | March 26, 2008 9:51 PM

Here's an idea... Fed decides banks (and other lenders) get to mark the value of their bank owned (i.e. foreclosed) houses at no more than 2/3 of current market value. That should encourage them to clear some inventories and give new home buyers affordable houses in the process.

Right now I feel like they're holding on waiting for something to happen just because they don't want to realize losses. A quick correction in prices might be painful at first, but it gets the problem over with and empty houses are a much bigger drag on the economy than cheaper but occupied houses.

Posted by Nelson | March 26, 2008 9:58 PM

I am intrigued by this idea, it seems to make a emotional and rational sense to me. As a homeowner who deliberately took a smaller loan than the bank was trying to push on me, I don't like the idea of speculators being bailed out. The definition of speculator should definitely include anyone who thought the solution was to refinance in a couple of years.

My question about this is: how do you keep the glut of homes going onto the market at once from depressing home values through the floor? This does affect me, as it makes my home worth less.

Thanks, and I'll take my answer off the air.

Posted by Kevin Stevens | March 26, 2008 10:01 PM

I should have said "mitigate the effect" of home prices going through the floor. My bad.

Posted by Kevin Stevens | March 26, 2008 10:12 PM

Federalism solves this problem.

Posted by secret asian man | March 26, 2008 10:16 PM

I'm with Kevin on this one, and was about to make the same point.

There's no such thing as "walk away." This situation has lowered housing values for the people who were responsible. Megan's plan puts an inordinate share of the pain on these good homeowners, while not saddling the irresponsible with the 10 years of bad credit that they have earned.

Posted by RobM1981 | March 26, 2008 10:26 PM

Blake wrote:

>>> "The worst is that you think that homeowners who are in arrears with mortgage and underwater with the equity in their home have all kinds of 'extra cash in the bank.'"

It's pretty obvious from her post that she doesn't think that. Hence she writes, "whatever extra cash they have...," which would indicate to any rational, non-Blake reader that this extra cash is not enough for a mortgage payment (or at least not enough for many). The idea, I think, is to make the deal more palatable to the mortgage holder so they'll agree to it.

>>> This is beyond moronic--it's blind numbingly stupid. If people had "extra cash" in the bank, they'd pay their mortgage on time.

Again, a rational, non-Blake reader would understand that a Chicago MBA probably has a pretty firm grasp on this concept.

>>> Good God. Think before you write.

The term "mote" comes to mind.

=====

Megan,

I've been following the gauntlet that you've run today. I hope that someone who is able gets you some flowers or a new Wii game, or something. Based on what I've seen, you're a bigger man (er, person) than I--and not simply because you're an inch taller.

Any thoughts on shareholder activism? I've a paper due on Monday and could use some pithy commentary.

Sincerely,
Michael B.

Posted by Michael B. | March 26, 2008 10:42 PM

Have Fannie Mae offer 50 year, fixed rate refis at market rates.

That'll help the majority of people who are just trying to ride this out.

Won't help upside down speculators. But we don't want to help upside down speculators.

On the finance players who bet the stake at 30-1 leverage,they should go down. Nationalize them, or bankrupt them. The Fed should have taken back its 30 billion and left Bear's stockholders with zero, in response to the renegotiated share price.

Posted by jayackroyd | March 26, 2008 10:52 PM

They don't get to keep a house they can't afford, but they also don't get crippled for the next ten years by an unwise but somewhat understandable urge to own a nice house.

The effect of the bankruptcy bill makes this scenario unrealistic. People are much better off sending in their keys, not making payments, and being foreclosed upon, while paying down their credit cards.

Foreclosure isn't the end of the world. Moreover, they've been encouraged to treat their homes as financial assets. So, what the hey, hold it until they have the equivalent of the last margin call and walk away.

And, frankly, if the bank was willing to lend them 20 or 50 to 1 leverage, then, well, the bank made a bad decision, and should pay for its folly. I don't understand why this doesn't go both ways. The bank issued an imprudent loan. It went bad. That's the bank's fault as well as the borrower's.

Posted by jayackroyd | March 26, 2008 11:04 PM

They don't get to keep a house they can't afford, but they also don't get crippled for the next ten years by an unwise but somewhat understandable urge to own a nice house.

The effect of the bankruptcy bill makes this scenario unrealistic. People are much better off sending in their keys, not making payments, and being foreclosed upon, while paying down their credit cards.

Foreclosure isn't the end of the world. Moreover, they've been encouraged to treat their homes as financial assets. So, what the hey, hold it until they have the equivalent of the last margin call and walk away.

And, frankly, if the bank was willing to lend them 20 or 50 to 1 leverage, then, well, the bank made a bad decision, and should pay for its folly. I don't understand why this doesn't go both ways. The bank issued an imprudent loan. It went bad. That's the bank's fault as well as the borrower's.

Posted by jayackroyd | March 26, 2008 11:04 PM

For anyone who is anti-regulation, moral hazard is WHY we have regulation. We are going to see the worst economic disaster hit our shores since the 1930's, with little, if any reason for us to get out of this mess unless we decide to re-industrialize this country and actually start to produce something.

See - the problem is pretty simple: we borrowed to keep our lifestyle equal to what it was when we actually produced goods. Now we are paying the piper.

Please - would anyone tell me where the next great investment in America is going to come from that is going to spur us out of this mess?

Posted by Brad | March 27, 2008 12:28 AM

Couple questions...

If the issue is so large the economy would be crippled without a bailout, how can we afford to pay it without major inflationary effects (there's no free lunch and printing more money won't help right?)

If it is not large enough to cause major inflationary effects then doesn't that mean the problem can be weathered?

I tend to think that if the economy is threatened because everyone does not have a pony, agreeing to buy everyone a pony will make us worse off...

Or in other words, we are into this situation because people are after the easy money (I'm no different here!) and our solutions sound very similar to the easy money schemes to begin with.

Of course I don't necessarily think no-action is the best way to go..

Posted by sam | March 27, 2008 12:32 AM

What several people don't realize ...

Home prices are not the same thing as home values. Just because the price rises doesn't mean the home is providing any additional shelter. Same thing with falling prices... it's not providing any less shelter. The lower price might reduce the property taxes... so you might actually be *better* off with falling prices - assuming you're actually using the home to live in and not as a short term investment.

The problem now is prices are above values, and this is creating a surplus of houses. Once prices fall to the market clearing rate, we'll have full neighborhoods again and happy home owners (especially those that just bought at the new lower price). The only thing that can keep the downturn going is an attempt to keep prices high.

Posted by Nelson | March 27, 2008 12:53 AM

"Make things too easy, and people will be encouraged to take more insane risks; make them too hard, and the economic results will force the rest of us to pay for their sins."

Duh. And yet, Bernake and his goons make that decision ever time they make open market operations.

Posted by Stephen | March 27, 2008 1:12 AM

sam:

This should help with your question:

http://www.federalreserve.gov/pubs/bulletin/1997/199711lead.pdf

Posted by AT | March 27, 2008 1:28 AM

Megan's idea seems somewhat reasonable. The idea being floated i Congress right now is borderline insane. They want the feds to simply buy up people's big mortgages and give them smaller ones. That's transferring billions in wealth to bad borrowers on the backs of good ones.

Posted by Mike | March 27, 2008 1:50 AM

The effect of the bankruptcy bill makes this scenario unrealistic. People are much better off sending in their keys, not making payments, and being foreclosed upon, while paying down their credit cards. Foreclosure isn't the end of the world. Moreover, they've been encouraged to treat their homes as financial assets. So, what the hey, hold it until they have the equivalent of the last margin call and walk away.

This technique has its limits, because homes are not merely investments, they are physical properties that require maintenance and oversight. There was an article recently, I forget where, about a responsible homeowner in a newer suburban neighborhood where several nearby homes had been foreclosed and effectively abandoned. With nobody around to mow the lawns and fix any routine weather damage, the transients, hookers and drug dealers quickly spotted these properties and figured out that they could move in with impunity. Said homeowner literally found herself living in an outer-city ghetto.

That has far broader consequences than merely the relationship between, and mistakes made by, the bank and the lender. As such, there may be a middle ground where some of the cliffhangers are worth throwing a rope if it means they will stay with the property, for the sake of civil society generally if not the irresponsible borrowing and lending parties.

Posted by anony_mouse_ | March 27, 2008 2:00 AM

Megan, a better idea than wiping the loan off their credit record is to persuade the credit agencies and credit scoring systems to downweight foreclosures during the 2007-2010 period. That way, people get hurt but not crippled. You could even have a lesser weight for "uncontested foreclosure" where they, as you suggest, just agree to turn over the house.

Posted by Mike | March 27, 2008 2:08 AM

The one thing that has stood out to me during this ... ah ... shot in the foot incident is what started it all.

Way back when, the starting gun was an announcement from one of the Funds that was heavily in to B/C Mortgages (aka Sub-Prime) was experiencing a higher than anticipated failure rate of the loans. To date I have yet to see anyone say that the Funds that bought up the B/C loans had either a) experience outside of A Mortgages or b) had taken into full account that B/C loans where going to be higher risk (the justification of the higher interest rates) and therefore have a higher failure rate.

Between that first announcement and the confidencey rush there was really nothing coming out saying what the anticipated failure rate *was*. After the confidencey rush was on it didn't matter. Funds that were in A Paper were suddenly looking at them oddly and trying to figure ways to unload them fast. It didn't matter that if they had been tooling down the middle of the road making the Funds money on time and on target.

But in a Sub-Prime Market, experience counts. And not really all that much if it's A Paper experience.

I've always wondered, did the Funds accounting departments, with little (if any) B/C Paper experience just lift the A Paper projected failure percentage and drop it into the B/C Paper business plans? Because if they did, even a few of them, then of course you're going to 'experience higher than anticipated failure rates of Sub-Prime loans'.

Not, mind you, that we'd ever find out at this late date.

Posted by Michael | March 27, 2008 6:07 AM

The moral hazard isn’t the wipe-out (not bail-out) of Bear Stearns; it’s the bail-out of the counter parties to Bear Stearns. The Fed insured the contracts made by Bear and assumed by JPMorgan while wiping out the equity of Bear’s owners. It’s similar to the FDIC insuring the depositors of a S&L while allowing the S&L to go out of business.

The owner’s risk has increased since the Fed’s move was pre-emptive. The counter party risk between financial institutions decreased. (On the Monday after the wipe-out, stocks of other investment banks fell while swap spreads tightened.) Like S&L depositors, capital markets institutions can worry less about the credit worthiness of their counter parties. This is a moral hazard encouraging riskier behavior.

Politically, the Fed and other federal institutions will add liquidity to revive the housing market. Sixty five percent of households are home owners and this is a democracy. Already the GSEs (Freddie and Fannie) are urged to increase their portfolio and the Federal Home Loan Banking System is allowed more leverage.

Many Wall Street firms are still trying to de-leverage or avoid leverage. We can expect continued drastic actions by the Fed to expand credit, in the near future. If it succeeds credit problems will be postponed until a later date at which time it will be much bigger. Moral hazard is the purpose of government intervention—protecting people from the consequences of their actions.

Posted by Jason | March 27, 2008 8:34 AM

It seems all of you are missing the point. The price of housing needs to come back to historical norms, not bubble prices. That means that median house prices should be roughly 3 times the median income in any area. House prices must fall - and by a lot.

For example: In Northern Virgina (Fairfax county) in 2006 the median income was $55,000. Median house price was $530,000 (I'm doing this from memory so if not exact go with the message). A ratio of 10 to 1!!!

To get to historical rates either incomes need to go up to around $175,000 or prices must fall to around $165,000. Since I doubt that incomes will be going up I am sure that prices will fall, and fall a long way. We are already seeing 20-30% drops YOY in many of the bubble areas - which are almost all in blue states around the big blue cities. Notable exceptions being Las Vegas and Florida.

The people who are going to get killed are the upper middle class on the coasts, especially Florida and California who bought since 2005. They are literally sitting on an asset that is worth half what they paid for it with no hope (short of massive inflation) of ever getting back to break even. If you are in a non-recourse state, your underwater a couple hundred thousand, you bet business decision is to mail in the keys and let the bank take the loss. You can recover from a foreclosure. Paying off hundreds of thousands of dollars of principle plus interest on an asset thats not worth what you paid for is just plane dumb.

Prices must fall back to affordable levels. And that fall will take down a lot of banks.

Posted by buffpilot | March 27, 2008 9:03 AM

From today's WSJ

In his report, Mr. Missal said that in one instance, a KPMG partner who led the New Century audit team castigated a subordinate who had questioned one of the company's accounting practices as it prepared to file its 2005 annual report with the Securities and Exchange Commission.

It seems like we need to find a way to change the incentive systems we have in place. Obviously, those who are concervative and cautious by nature are going to underperform during a boom. However, their caution can be highly valuable in protecting an organisation from the eventual bust.

What organisational and incentive changes can a firm like KPMG introduce to empower and reward the "castigated subordinate"?

Posted by jmo | March 27, 2008 9:04 AM

Buffpilot,

FYI the median houshold income in Fairfax County is $100,318. The median faimly income is $119,812.

Which means houses should be selling for 360k not 170k.

http://www.fairfaxcounty.gov/demogrph/gendemo.htm#inc

Posted by jmo | March 27, 2008 9:12 AM

Megan,

I'll try not to snark here, but you say some troubling things:

"Set a three month period during which people can hand the house back to the bank in exchange for canceling the loan and surrendering whatever extra cash they have in the bank."

How much extra cash? all of it? How can you prove that they don't have cash in some account somewhere? If they didn't why wouldn't they use it to pay bills? Or, if they were a real capitalist, they would withdraw all their money and hold it as cash until this bailout goes through. No money in the bank!

Second, this is sort of what is happening right now, and why we are in so much trouble. It is sad that you don't realize this: people are turning their houses over to the bank. The banks don't want houses. Especially not ones that have lost 50% of their value and had an original LTV of 100%. The bank takes a hit on these foreclosures. Just look at the REO properties for Countrywide. Those are all losses. And all these homes going on the market increase supply which reduces price, and more homes go underwater. Your bank holiday would do nothing, because the pittance any borrower has saved won't cover the amount that the loan is underwater. Otherwise we wouldn't be in this mess. Do you think this stuff through before you post? Oh sorry, there I snark again.

Posted by freddiemac | March 27, 2008 9:28 AM

Freddiemac, I don't understand why you assume that I am interested in saving the banks, rather than the homeowners.

I am well aware of the foreclosure inventory; I wrote a piece on it two days ago right here on our website, where you might easily have found it if you had done a small amount of basic research. But we cannot pay homeowners to stay in houses they can't afford, or banks to extend ridiculous loans on the assumption that the taxpayer will bail them out. That sends a terrible message, and the taxpayers will revolt.

I'm looking for a way to facilitate an orderly liquidation while mitigating the economic fallout and personal tragedy. Perhaps this is not a good idea; I'm really just musing aloud. But your snark is entirely unwarranted; if you had read any of my pieces on housing, you would know that I am in fact intimately familiar with the details of the housing market.

I do not actually expect my readers to do this--y'all have lives. But if you're going to go snotty, you want to be very, very sure that the target doesn't know what they are talking about. Otherwise you look more foolish than you could ever have hoped to make your target appear.

Posted by Megan McArdle | March 27, 2008 9:51 AM

Buffpilot’s numbers were off but his/her concept was right. Mal-investment should be liquidated; this is why bust follows boom. The pain is not the problem but the symptom of the problem which is credit-induced bubbles. It was exasperated by government regulations the encouraged “affordable housing initiatives” to unqualified borrowers. Sadly, I don’t think the liquidation is politically feasible.

Posted by Jason | March 27, 2008 9:55 AM

But we cannot pay homeowners to stay in houses they can't afford, or banks to extend ridiculous loans on the assumption that the taxpayer will bail them out. That sends a terrible message, and the taxpayers will revolt.

...unless the taxpayers are convinced (by those banks & the financial industry) that the sky will fall on them if they don't...

Posted by TakeFlight | March 27, 2008 10:40 AM

Megan,

Perhaps my point was obfuscated by an unnecessary remark. Therefore I shall try to restate: I don't believe that your plan will really do much to benefit either the homeowners or the banks. The homeowners still lose their homes, but more importantly equity will still slide and more borrowers will think it less important to stay in their homes and make payments. The banks will still lose money. I really don't see who this helps. Really all I see it doing is saving a few credit ratings. Is that such a priority?

Posted by freddiemac | March 27, 2008 10:46 AM

The idea being floated i Congress right now is borderline insane. They want the feds to simply buy up people's big mortgages and give them smaller ones. That's transferring billions in wealth to bad borrowers on the backs of good ones.

I think (hope!) this is most unlikely. Public opinion from what I hear & read seems massively against any bailout for either borrowers or lenders. NYTimes had a story a few weeks ago with a comments section which ran about 300 against to 15 in favor of assistance to borrowers.

My guess is that if Congress seems about to pass some legislation to this end, the outcry will make the response to last year's immigration look mild.

Posted by Gene | March 27, 2008 10:50 AM

Or, an alternate proposal is that the government sends FHA agents to foreclosure auctions and buys them up wholesale. This will do several things.

One, the borrower does lose their house, but their mortgage is considered paid in full and their credit is spared.

Two, the bank does lose money because they aren't able to collect all that interest they had counted on (leveraged). However, the banks don't lose as much money as they would if the loan passed from a foreclosure auction to REO status, which is quite often the case.

The government will lose money on this, and it will cost us taxpayers. However, it is possible that the government can reap benefits from this by renting out properties until markets recover and then selling off the government owned properties (possibly making many of these properties a sort of rent to own deal).

I don't think this is the ideal solution. I don't think there is an ideal solution. However, it would do one important thing which is stop the slide in equity. Stopping the equity slide is similar to stopping a bank run; it stops the perception of losing money. Much like a bank run, a declining market is based on the perception that markets are declining.

Ok Megan, now you snark on me :)

Posted by freddiemac | March 27, 2008 10:54 AM

I think Megan misses the point when she suggests letting people walk away from their houses. As someone who lives in a neighborhood with several foreclosures, it's clear that people already can and do walk away. I have no data on if it was their decision or the banks, but I don't think it matters.

What is important is those houses are empty. Encouraging even more people to walk away isn't going to solve that problem.

The problem is new people aren't moving in. The reason new people aren't moving is is the property owners are still asking for prices that are too high. There is no good economic reason for the housing prices to not drop. My guess is the banks don't want to admit that what they actually have isn't worth what their balance sheet says they have. Once the banks are forced to reconcile their balance sheets with reality and take the loss, the market can take over and put people in the newly affordable houses.

Posted by Nelson | March 27, 2008 11:16 AM

"The government will lose money on this, and it will cost us taxpayers. However, it is possible that the government can reap benefits from this by renting out properties until markets recover and then selling off the government owned properties (possibly making many of these properties a sort of rent to own deal)."

Yes, the government's record with housing is so wonderful.

Posted by Mike | March 27, 2008 12:22 PM

Jason,

I liked both of your comments, but the word you meant to use is "exacerbated", not "exasperated".

Posted by Yancey Ward | March 27, 2008 12:27 PM

freddiemac:

However, it would do one important thing which is stop the slide in equity.

But would you agree that the government needs to let equity slide until we get prices back within their historical norms?

To combine what me and Buffpilot said - The houses that are 550k need to get down to 360k. The government just needs to facilitate an orderly transition to the new prices.

Posted by jmo | March 27, 2008 12:40 PM

Yes, thanks, Yancey. It’s my sloppy proof-reading that’s exasperating.

Posted by Jason | March 27, 2008 12:44 PM

Mike,

You mean like inventing the 30 year fixed? The record looks as good as the private sector at this point!

jmo,

While you have a point that equity was inflated beyond normal market conditions, I liken the equity drop to a bank run, and thus the impetus to stop the run is similar. Much like a bank run hurts good banks as well as bad, a perceived equity run gives buyers the impression that prices need to drop. I like to say that inherently all real estate is local. While in some regions equity needs to decline, I don't know that such is true in all places where things are falling.

The government can, through various means, soften the landing for the equity drop. The chorus seems to be singing that tune these days, and some libertarians excepted it seem unanimous. What doesn't seem clear is course of action.

I like to say that the "liquidity crisis" can be abated if the government simply buys up and writes down hundreds of billions worth of bad securities. The banks would lose some money, but not too much that they close. The government may lose money, but the easing of liquidity could give banks the juice they need to start refinancing all those ARMs. And if the market stabilizes, the bonds that the government buys may not necessarily tank, and the government could see a partial return on investment.

One thing to consider is the way that this affects our consumer economy. People took out home equity lines of credit during the housing bubble, and that money they borrowed fueled consumer spending. Now that the bubble burst, the collateral people put up isn't worth what it was. Now we are seeing a negative savings rate. This is bad news for consumer spending, or so I'd hazard to guess. So it is in the best interest of the economy of the whole if mortgages stop being underwater.

Or to sum it up, stopping the equity drop may not return the markets to where they should be in the short run, it doesn't mean that they won't get there in the long run. It stands to reason that the supply and demand curves will balance out after a few years, and we will simply see equity remain flat until the market becomes more desireable. In the short run though, it can soften the looming recession and keep more banking solvency problems from arising.

Posted by freddiemac | March 27, 2008 1:02 PM

I like to say that the "liquidity crisis" can be abated if the government simply buys up and writes down hundreds of billions worth of bad securities.

Why should tax payers be held to pay for businesses making bad loans? It doesn't matter if some companies go bankrupt. The houses, the only things of *real* value in the equation, will still be there. The money misallocated is already gone. It's in the hands of the sellers and builders. The losers are the ones underwriting the loans. They made a mistake. Mistakes cost money. They knew that going into the game.

Part of being an investor is that once in a while a bad decision will lead to a loss. That is normal. The Fed shouldn't bail anyone out above and beyond the 100k per person per bank account through the FDIC.

The liquidity crises will end once assets are priced at correct levels. There is a lot of money in this world and what it wants is knowledge of risk (correct asset prices) going forward, not a bailout of past mistakes.

Posted by Nelson | March 27, 2008 1:26 PM

Nelson,

The government probably shouldn't do that. However, the net result would be similar to the S&L bailout of yesteryear, in that it would stop banks from going belly up and stop a potential economic free fall. I would argue that if the government were to pursue such a course, which makes economic sense in some regard, they should follow it up with a regulations backhand.

Posted by freddiemac | March 27, 2008 1:51 PM

freddiemac,

Then how about this: The "historical norm" price of home X is 380k, it sold 18 months ago for 500k. Someone needs to take the 120k loss. So, the homeowner is on the hook for 40k, the banks for 40k, the taxpayer for 40k.

Posted by jmo | March 27, 2008 2:50 PM

"That is normal. The Fed shouldn't bail anyone out above and beyond the 100k per person per bank account through the FDIC."

Nelson,

The 'Fed' isn't the Source of FDIC funding, you are..

Posted by MEH | March 27, 2008 7:19 PM

Re: People are much better off sending in their keys, not making payments, and being foreclosed upon, while paying down their credit cards.

While I don't support 2005's the BK "reform" there is a lot of disinformation floating around about it which should be corrected. It absolutely not true that people with insupportable credit card debt cannot declare bankruptcy: they still can. At least half of them will still qualify for Chapter 7, wiping out the debt in toto. The rest will be placed in a Chapter 13 repayment plan (which has been extended from three to five years), although note that higher income people have always been directed into chapter 13.

Re: Please - would anyone tell me where the next great investment in America is going to come from that is going to spur us out of this mess?

Probably some combination of alternative energy, biotech and nanotech.

Re: With nobody around to mow the lawns and fix any routine weather damage, the transients, hookers and drug dquickly spotted these properties and figured out that they could move in with impunity.

Local governments should be doing doing the upkeep and security and billing whoever has claim on the property, and if necessary slapping a lien on the property to be satisfied at the time of sale if they can't collect sooner. And shame on those that are failing this basic function of their existence.

Posted by JonF | March 27, 2008 8:02 PM

MEH -

I stand corrected. I still maintain that the government should not get financially involved beyond what guarantees are already in place. They can regulate if they want to, but any such regulations should force a reckoning so that the asset prices "on the books" can no longer be held above market clearing values.

Posted by Nelson | March 27, 2008 9:05 PM

JonF,

Correct again, though your statement deserves closer scrutiny:
"Local governments should be doing the upkeep and security and billing whoever has claim on the property, and if necessary slapping a lien on the property to be satisfied at the time of sale if they can't collect sooner. And shame on those that are failing this basic function of their existence."

I think this statement should serve as a warning to places like Cleveland that they should probably take drastic measures against the foreclosures by setting up a land bank to reposess houses unoccupied and derelict for too long and demolish them in order to stem the loss of property values, and therefore property taxes.

In some places the billing for back taxes will make a place that is foreclosed for too long unsaleable. All the more reason to demolish. A sad consequence of market vicissitudes.

Posted by freddiemac | March 27, 2008 10:31 PM