Saturday, September 27, 2008

A "Bail Out" Proposal that the Median Voter Will Support

Congress cares about what the voters want. The median voter is a home owner. Home owners want their key asset to go up in price. Chris Mayer proposes a solution to reduce defaults and prop up home prices. He wants to lower interest rates down to their historical spread. If people could borrow at these interest rates (financed with "bail out" $), then demand for housing would rise, home prices would rise and defaults would slow down.

His proposal would redistribute income to the middle class at the expense of the poor and the rich. Why? The poor are renters so they would now face higher prices for housing and they are tax payers and part of their taxes would go to subsidizing the interest rates of home buyers. The rich would face higher taxes due to the progressive nature of the tax code and the rich will want "Jumbo" loans (greater than $700,000) and thus won't qualify for these subsidies that Mayer proposes.

I must admit that there is a key detail in all of this that I don't get. Suppose that the Treasury took the set of homes where the owners have defaulted on their mortgages and auctioned them off to new buyers at lower prices. Yes, Wall Street would take a loss but how much capital has been destroyed?

So, suppose that 3 million homes are in foreclosure. That sounds quite large.
Suppose that they were worth $400,000 each and now are worth $200,000 each. That's a whopping 50% decline in average prices.

that is "destruction" of 600 billion dollars. Where does 700 billion come from? That's the bailout number.

I'm not a macro economist. What "multiplier effect" am I ignoring?

Here is Chris Mayer's plan.

New York Times
September 27, 2008
Op-Ed Contributor
Help Housing

A T the heart of the financial crisis is an unprecedented decline in house prices. Yet the government response so far has been to try to prop up insolvent financial institutions while doing nothing about the underlying housing problem. The proposed Wall Street bailout would not stop the next wave of defaults, which are coming from the rapidly rising delinquencies in near-prime mortgages.

The government needs to directly stabilize the housing market. This is equivalent to treating the infection with antibiotics, instead of applying a cold compress for the fever. Both the fever and the infection need treating.

The first step should be to reduce mortgage interest rates. In a normal mortgage market, rates are about 1.6 percentage points above the interest rate for 10-year Treasury notes. Recently, the difference has been closer to 2.5 percentage points.

The government is in a great position to cut rates by about a point: Through Fannie Mae, Freddie Mac and the Federal Housing Administration, it now controls nearly 90 percent of all mortgage originations. These lower rates would apply to most home buyers who take out a loan under $729,750 for a house that they will live in.

Along with lower rates, the government should provide temporary down-payment assistance for buyers. The government could, for example, match the amount of money that buyers use for a down payment, up to $15,000. Because the government now controls the bulk of all mortgage financing, this money could be provided directly at closing. Homeowners who refinance their current mortgages could also receive assistance, allowing them to avoid foreclosure.

Programs like these would draw buyers into the housing market and reduce the backlog of unsold and vacant homes. Investors and speculators would be ineligible and would face the full cost of their mistakes.

By stabilizing house prices, these programs would benefit the bulk of Americans, who own a home but did not get involved in the subprime mortgage market. Price stability would more directly achieve the goals of the Wall Street bailout: increase the value of mortgage-backed securities (by increasing the value of the underlying houses) while injecting government capital into the financial system.

Some in Congress have suggested allowing homeowners to go to bankruptcy court to lower their mortgage payments. But this would only make credit more expensive by reducing the willingness of companies to lend money. It would also worsen the current problems by letting bankruptcy judges reduce mortgage balances — imposing even greater losses on the owners of the mortgages, whose problems are at the heart of the financial crisis. Such a program would also be limited to only the most indebted and, in some cases, financially irresponsible homeowners.

Some might argue that propping up house prices is what got us into this mess. But with the recent decline in house prices, my calculations suggest that the cost of owning a home today, relative to renting, is about 10 percent lower than its average over the past 20 years.

The credit crisis will not be over until house prices stop falling. Direct assistance for home buyers and homeowners is the best, and the fairest, way to make that happen.

Chris Mayer is a professor of real estate and the senior vice dean of Columbia Business School.