Housing Bailout-- part 1

From CATO's Alan Reynolds in Monday's WSJ...

Starting with who will actually be subsidized by the President's plan...

It is not quite right to describe the new White House plan as a bailout of subprime mortgage borrowers. Actually, it is a bailout for a tiny fraction of those with adjustable-rate mortgages (ARMs), not subprime loans per se. Nearly half of all subprime mortgage rates are fixed-rate loans, and only 32% of ARMs are subprime....

The Bush administration claims the plan will help "up to" 1.2 million people. Most of that promised help consists of nothing more than another phone number to call for counseling about refinancing -- a redundant service unlikely to prove wildly popular....

If risky subprime borrowers were actually supposed to be the main beneficiaries of such refinancing assistance, then it would have been the height of irresponsibility for President Bush to suggest greater involvement of the Federal Housing Administration, Fannie Mae and Freddie Mac. Shifting default risk to U.S. taxpayers could be very costly.

In reality, the only financial aid in this plan goes to those who qualify for the five-year freeze on mortgage rates -- a curiously selective little group, estimated to number between 145,000 and 360,000.

When it comes to resetting mortgage payments below the level borrowers agreed to, why give a special deal to Sam but not Suzie? On the day the plan was unveiled, the Mortgage Bankers Association reported that 0.78% of mortgages went into foreclosure in the third quarter, and that 5.59% were far behind in their payments. Neither group qualifies for any help under the Bush plan. Neither does anyone with imperfect timing -- those who took out a mortgage before 2005 or after this July. Among the few lucky enough to slip through that narrow window, the primary criterion for a rate freeze is a weak credit rating, below 660. And what happens after five years? Presidential contender Sen. Hillary Clinton is already talking about stretching it to seven years, and that bidding war has just begun.

On the face of it, these criteria for political favoritism seem only marginally more sensible than limiting special loan terms to, say, short people or redheads.

And then, later in the essay, skewering some of the conventional wisdom on this topic...

The political excuse for getting the government involved in helping a few politically-favored borrowers is based on false assumptions that subprime mortgages were usually used to buy a house, that a huge percentage of subprime loans face foreclosure, and that the main reason for foreclosure is rising interest rates.

All three conventional assumptions were undone by a new study from the Boston Fed. Its research shows that "most subprime loans are refinances of a previous mortgage." It estimates that "about 18% of people who finance home purchases with subprime mortgages will eventually experience foreclosure" within a 12-year period.

Most importantly, the Boston Fed economists found that most foreclosures do not result from adjustable rates going up, but from local house prices going down. They "attribute most of the dramatic rise in foreclosures in 2006 and 2007 in Massachusetts to the decline in house prices that began in the summer of 2005. Subprime lending played a role but that role was in creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages."

If you owe more money on a house than the house is worth, foreclosure can be a perfectly rational choice. Suppose Mr. Smith bought a house for $300,000 with no money down, but the value of that house has now fallen to $270,000. If he refinances or sells the house, he would still owe the mortgage servicer an extra $30,000. Falling home prices in many areas provide a powerful incentive to default on the loan, live rent-free for many months, and then hand the keys to the bank.

Finally, his punchlines...

Some in the news industry have described all this heavy-handed political intervention as the Bush administration's "free-market approach" to the threat of nonperforming mortgages. On the contrary, honoring contracts and property rights is absolutely essential to the proper functioning of a free society and free economy. A mortgage is a binding contract between consenting adults. A mortgage-backed security is private property. It is the antithesis of a free market for the government to fix prices, pressure mortgage service companies into renegotiating contracts, and thereby expropriate property rights of those stuck holding mortgage-backed securities.

Another president, Richard Nixon, gained ephemeral popularity by freezing wages and prices on Aug. 15, 1971, but the end result was disastrous for the economy. The Bush administration may hope now for some political benefit from freezing interest rates for a select subgroup of high-risk borrowers. But whenever politicians attempt to protect borrowers and lenders from their folly, they just encourage more folly.