“Why am I being punished for having bought a house I could afford? I am beginning to think I would have rocks in my head if I keep paying my mortgage.”

-Todd Lawrence, Norwich, CT homeowner with a traditional 30-year mortgage

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Herein lies the simple problem in trying to “save” so many mortgages: A huge swath of them should not be saved.  Some of that is due to price, some of it is due to not wanting to reward irresponsible behavior, but the bulk of it is simply because the people living in these homes cannot reasonably afford to pay for them, even after a 20-30% workout.

There are now more than 10 million “home-owers” underwater, with their mortgages greater than the present value of their homes. Since they have little skin in the game — thanks to banks that did away with down payment requirements — there is little incentive for them to tough it out.

Not surprisingly, it is FDIC Chairman Sheila Bair who is leading the push towards a mortgage workout plan. She wants policy makers to take action to help people stay in their homes — thereby taking pressure off of the FDIC, which insures the banks.

Why? More foreclosures = more bank failures = bigger FDIC obligations.

The problem with this current rescue plan is that it is designed to “prevent the continued downward spiral of the housing market.” But that is EXACTLY what the housing market needs — overpriced homes that are not selling need to come down in price. We had a normal price increase from 1996-2001, and then a near vertical set of price gains from 2002-06. Any framework for systematically modifying loans that fails to comprehend that is doomed to failure.

Here is the grim reality about home prices: They remain elevated by just about every historical metric. Look at the median income to median home price, or look at the cost of renting versus the cost of ownership. Look at the inventory for sale, relative to 5 year trailing price increases.

The bottom line is that in much of the country, prices are still too high. That’s reflected in all the inventory that is not selling.

And home sales typically tend to be a chain of prices and sales: The seller of the starter home tot he newlyweds then can move to the larger home with room for their growing family, and that seller moves to an even bigger manse, and so on and so on. But if the newlyweds cannot afford that first purchase, the entire chain gets slogged down.

The notable exceptions? Where foreclosures have driven prices down 40, 50 even 60%, home sales surge. Much of our leadership fails to understand that simple truism about home prices.

As we detailed in our “Fixing Housing Proposal,” you want to save the homes where there is a reasonable justification for a mortgage workout. This means where the home price can be reasonable, the mortgagee can afford it, and the mortgage holder willing to take a modest haircut. Otherwise, you reward bank lenders and home buyers who were utterly reckless, and punish those people who were prudent and responsible.

Moral hazard not only encourages recklessness, it leads to people looking to avoid responsibility for bad decisions. We see this in groups seeking credit card debt forgiveness — only because the current climate encourages it.

Previously:
Fixing Housing & Finance: 30/20/10 Proposal (9/22/08)

http://www.ritholtz.com/blog/2008/09/fixing-housing-finance-302010-proposal/

Sources:
Mortgage Plan May Aid Many and Irk Others
DAVID STREITFELD
NYT, October 30, 2008

http://www.nytimes.com/2008/10/31/business/31bailout.html

Treasury, FDIC Said to Craft Plan to Curb Foreclosure
By Alison Vekshin and Robert Schmidt
Bloomberg, October 29 2008

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=asOlfO5uPwIY

Relief Nears for 3 Million Strapped Homeowners
MICHAEL R. CRITTENDEN and JESSICA HOLZER
WSJ, OCTOBER 30, 2008

http://online.wsj.com/article/SB122531677860781723.html

More U.S. Homeowners Have Mortgage Higher Than House Is Worth
Dan Levy
Bloomberg, October 31 2008

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYyk2_TLjGao

Groups seek credit card debt forgiveness
(AP) October 29, 2008: 9:47 PM ET

http://money.cnn.com/2008/10/29/news/economy/creditcard_bailout.ap/index.htm

New Loan Fix Is Unlikely the Last
FDIC Plans Mortgage Guarantees; Lawmakers Consider Pressuring Reluctant Investors
JOHN D. MCKINNON and JESSICA HOLZER
WSJ, OCTOBER 24, 2008

http://online.wsj.com/article/SB122477138431362499.html

White House Is Said to Want Limits on Loan-Guarantee Proposal
Alison Vekshin and Robert Schmidt
Bloomberg, October 31 2008

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQomFeVyf9tk

Category: Bailouts, Economy, Psychology, Real Estate, Taxes and Policy

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

21 Responses to “Moral Hazard of the Coming Mortgage Bailout”

  1. jason says:

    Did any one read Mish today?

    Volvo Truck Orders Decline 99.63 percent; Auto Industry Faces Crash in US.

    Is that number real? It just boggles my mind.

    http://globaleconomicanalysis.blogspot.com/

  2. phb says:

    I’m pissed…what about me? I sold my house in mid 2006 because I believed the market was too hot and wanted out before the decline in housing prices bankrupted me. I even took a $50k loss to exit. (Ironically, the buyer stopped paying the mortgage 9 months ago and left the keys on the kitchen counter)

    I sure as hell would like some of my loss back too, but I suspect nothing like that will happen. So, because I was “early” to exit, I suffer? Where’s the logic? This is like 1999 all over again when I sold LU before the last 100 point run-up before falling to god knows what…

  3. karen says:

    jason, that info actually came out last week… bloomberg posted it on 24 Oct.

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_MlLf33J7Jw

    Now, F is recalling 1000 workers to build F-150s. ???

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aLY8v9mw2ycE

  4. leftback says:

    How to be fair to Todd and to those of who rented during the housing insanity is probably the most difficult issue the next administration has to deal with, in my opinion. Nobody wants to see a Great Depression II but there has to be opportunity for people who have saved to buy houses at reasonable prices. I don’t want to have to bend over again for the sake of those who got in over their heads while I lived within my means.

    The Halogen Guides thing is beyond annoying Barry.

  5. Dr. Kenneth Noisewater says:

    Don’t worry, President Obama will pay your gas and mortgage bills for you…

    http://www.youtube.com/watch?v=L6ikOxi9yYk

    (Not to throw rocks, but that is just too darned funny, almost as funny as the singing kids video…)

  6. phb says:

    Oh, and no, I didn’t buy after I sold, I’ve rented. Waiting patiently for the bubble to pop and over-correct on the downside, then I would buy. Looks like this idea, while sound in logic, is being taken away from me too…wtf? Anyone?

  7. I-Man says:

    Ok… Here’s a new take:

    I’m 29. Live in the Pacific NW.

    My wife and I began looking for a house to buy in 2005. It was crazy…. multiple parties bidding up houses like hotcakes. It was super competitive.

    We’d go look at a house and there would be five other people checking it out, and you didnt feel like you could even go home and “sleep on it” because before your eyes closed someone would have come in and pay up for it just to lock in a deal.

    Needless to say we kept getting outbid, and stubborn I-Man kept refusing to pay up for these houses that were way overpriced. Frustrating as hell, but we kept on renting.

    We tried three separate times, between 05 and 07 to get a place. Each time we had loans all set, but kept getting outbid on the houses.

    Fast Fwd to Spring of this year… Suddenly, all the spec buying ceased and houses started piling up in inventory. We finally were able to play the game without all the competition, and have a hope for buying a house without overpaying.

    We put 10% down for a 30 year fixed, and still had issues getting a loan, and we work for one of the best banks around, make modest pay, and have been responsible savers. I would suspect that many folks in our age group that have been priced out of the housing market are beginning to be priced “in.”

    We’re psyched to have been able to buy our home for what we paid, and you know what? I could give a shit what its “worth” now compared to when we bought it in June, because I plan on being there for at least five years. And further, I didnt buy a home to flip it and make coin, I bought it because I wanted to own a home.

    My point is: All the talk is about people who have already screwed up in the house game. What about all the folks that are finally able to get in to these houses? Look, 95% of the people that can work in this country have jobs. House prices are coming down… quickly. Hopefully, the recent actions by the Fed and Treas will be sufficient to get banks lending again to people with jobs and who are responsible borrowers, and who are willing to put some money down…

    From reading the headlines you would think every american is in danger of losing their job, has 5 credit cards maxed out, an option ARM, and a Hummer bought from HELOCs, and soon to be filing for bankruptcy. I just dont believe that’s the case.

    So, what is the moral hazard involved in encouraging another round of home ownership, that’s based on more responsible lending and more responsible buying?

  8. Renting in Mass says:

    You said it brother!

    I’ve had to skip the newlywed house. I need to jump right into the larger home for the growing family. I’m sure there are lots of first-time buyers in my shoes. I wonder what the ramifications of that will be.

  9. Iwasawa says:

    Bailouts for Wall Street and individual speculators could well result in revolution… it’s that explosive an issue.

    Crazy stuff indeed.

  10. biggypiggy says:

    You are missing one huge piece in your analysis. Income levels are a key function of the affordability of houses, but you also have to look at Rental rates as well. There is a direct corelation between rental rates and home prices. Take a look at the study put forth by the Center for Economic Policy Research which can be found at http://www.cepr.net/documents/publications/100city_2008_05.pdf . It provides relevant data on the top 100 cities in the US and was published in May 2008. It shows what areas will see equity in homes appreciate by 2012 and what areas will show equity deline by 2008. The Rule of 15 that the highlight is a good back of the envelope guide to looking at house prices in your area. Real estate is going to have to be evaluated on a market by market basis, not with broad strokes using national income data. Location, Location, Location is still relevant.

  11. sellthekids says:

    /me shouldn’t feed the trolls

    @Dr. Kenneth Noisewater:
    yeah, that is what she said. “having to worry about” = govt pays for my gas and mortgage
    and it is most def as funny as people teaching their children hate. nice work, doc.

    back to the topic at hand:
    the problem with intervention in any market is that it upsets the nature of the market. if we are going to let homeowners fail, then we also need to let banks fail. nationalizing and then “loaning” to these banks is not in the best interest of the economic system as a whole.

    i still do not understand *why* the bailout was a good thing. it appears to be a poorly built band-aid for a patient who has a major artery cut.

  12. biggypiggy says:

    Bailouts are needed when fraud gets into the free market system. The real estate market went unchecked and people took advantage of it. One of the worst housing markets has been Nevada. Want to know why? Read this article:

    http://www.bloomberg.com/apps/news?pid=20601109&sid=aGYlBrRCgtq0&refer=home

    The realtor and her fiance didn’t have a moral compass to guide them, they looked for ways to cheat the system and this couple figured out a way to use “straw” buyers to purchase 227 properties worht $107 million in Nevada. This is just 2 people that new how the system worked. My guess is there are lot of people that did this nationwide and a big chunk of the home foreclosures can be linked to fraud rather than Joe the plumber loosing his house. This fraud in the system is a key trigger to credit getting shut off and the only way to restore the balance of private capital that was pulled from the system is to have the government come in and replace that capital until free markets work through the fraud issues and the free market system starts up again because there is money to make in banking and lending and you the quests for profits always comes back in to play.

  13. sellthekids says:

    @biggypiggy:
    while i agree that fraud has played a role in the demise of the housing market, i am not certain that gaming the system has led to the financial tsunami we are seeing.

    imo, banks appear to be hoarding credit b/c of the ~$30 to $60 trillion CDS market, a workout which looms in the future. what was Lehman’s settling? $.0825/$1?

    if the housing market issue was banks worrying about fraud, then simply reverting to the standards for home loans used in say 1989 would fix the problem; worried about fraud, then require 750+ credit scores and 20% down. a 2/28 loan? did that even exist in 1989?

    meanwhile, allowing the value of homes to bottom naturally will price-in reality. the housing market was gamed for a long time. i know what i paid for my house, i know what it is worth to me, and yet my 2009 tax assessment (in TX) was +$30K above what i would assign as its value. our system from government down to owner has priced in a value that is not in keeping with reality.

    the only reason i can see a bailout being floated is that is stops the pain; that is the real problem – no one wants to hurt for the fix to a system out of control.

  14. Renting in Mass says:

    “Bailouts are needed when fraud gets into the free market system.”

    First, the idea that buyer fraud is the main driver of the problem is absurd. Second, that sentence doesn’t even make sense. Bailouts are need when fraud enters the system? Huh?

  15. truth08 says:

    This is exactly the type of consequences that occur when people try to control the markets. The Fed keeps interest rates to low in the early part of this decade to stave off a recession, but hugely inflated home prices result because it made economic sense at the time due to those policies. Now prudent homeowners with mortgages and homes they can afford are looking around and saying “Well why should I be punished for being responsible?” For some, it’s going to make economic sense to stop paying their mortgages even though they can afford them. Unintended consequences that make the situation worse.

    One way to thwart the thieves…

  16. Dr. Kenneth Noisewater says:

    Please Don’t Destroy My American Dream

    Linda explained that I could count as income the Worker’s Comp settlement I was receiving from the fryer accident, as well as the anticipated flood of tipjar income from a totally awesome blog post idea I’ve been thinking about. Using a sophisticated financial computer math program, she demonstrated how I could minimize my payments by selecting the 200-year interest-only ARM. The only formality was the credit check, and my TransUnion score was more than adequate after adding in the scores of my cosigners Kyle and Chuck.

  17. I don’t know man… when you say “[a] downward spiral of the housing market … is EXACTLY what the housing market needs,” I wonder if you kick dogs, spit on children and push old people out of the way as you walk down the streets of Manhattan. Shadoobie.

    What the housing market NEEDS is an economy not hooked on foreign capital and slave labor.

  18. patient renter says:

    As we detailed in our “Fixing Housing Proposal,” you want to save the homes where there is a reasonable justification … Otherwise, you reward bank lenders and home buyers

    How does “saving” any homes not reward lenders and home buyers, at the expense of those were had no involvment whatsoever?

  19. Winston Munn says:

    There are many good comments here but they appear to me as living art staging the old story of the 3 blind men who each misdescribed the nature of an elephant by relying on the single part of the elephant they felt.

    From my perspective, the problem is not really the inflated prices of homes, although that is a significant part of it – no, the real, underlying monster beneath the bed in this house is the ficticious capital that was created r-e-l-y-i-n-g upon those inflated home values as being real.

    Regardless of the spin, no one is actually trying to save homes or homeowners – what they are trying to save is the trillions of fake dollars stacked like logs upon a smoldering funeral pyre. This is the unspoken reasoning behind all the Fed alphabet soup of programs.

    Look at the ABCP outstanding – it fell about 50% from last July. Is there any reason to believe that the 50% remaining is liquid? If it is not liquid, and there is no market for it, is it really money? I would say no. At least not all of it. It has no transactional value, so it cannot be considered real money. MZM is overstated because of this misunderstanding, counting all of the non-transactionable capital as it were real, existing money. That concept also helps understand why in this deleveraging process the Fed pumps have not prevented the slide in equities prices – fictional capital has been destroyed faster than the Fed has been able to recreate it.

    A recent Reuters story stated that 60% of the nation’s mortgage holders are underwater – for a homeowner who can afford his mortgage payment and lives within the means provided by his income, this is not really important. It is only critical if you have previously borrowed or leveraged on top of the ficticious equity, then borrowed again off of that, then again, etc.

    Leverage is great if you are on the right side of the trade – it sucks big-time if you are wrong. And the greater the leverage the less margin for error until you go broke.

    Barry is right in that home prices simply have to fall – but against that backdrop are the guardians and keepers of the ficticious capital monster, those who would fight tooth and nail all the way down to continue to feed and nurture their falsely created demogogue beast.

    At least, that’s how I see this elephant….

  20. Pat G. says:

    And what about the moral hazard seeds that our government is planting for adult generations to follow? With all this “propping” going on, who knows what anything is worth?

  21. Mannwich says:

    Nicely put, WM. That is exactly what is happening and I don’t think it’s going to work. All of this fake money is being extinguished down the black hole…….

    And we aren’t even halfway through this mess, IMO.