The Next Government Created Housing Disaster

Government policy makers are discussing plans to help approximately 3 million homeowners avoid foreclosure by providing them with low interest rate loans. This initiative is expected to be similar to the FDIC’s response to the recent IndyMac Bank failure where mortgage holders facing foreclosure received restructured loans with interest rates approximating 3% for a period of five years.

Such intervention is misguided, would perpetuate the housing collapse and lengthen the economic downturn. It was precisely access to low interest rate, adjustable mortgages that got these distressed homeowners into trouble in the first place and distorted housing prices. Private institutions no longer offer such irresponsible mortgages because they encourage speculation, are prone to default and decouple home prices from the fundamentals of value. Yet the government is about to rely on similar low interest rate, adjustable loans to “fix” the foreclosure problem.

Such an initiative ignores the fact that government interference in the housing industry during the 1990s created the economic incentives which caused the Housing Bubble. Politicians pursuing a social agenda distorted the housing market by pressuring Fannie Mae, Freddie Mac and lenders to issue low down payment, low introductory rate, adjustable mortgages to subprime borrowers.

The government proposal relies on the same Ponzi Scheme logic that perpetuated the Housing Bubble. The only way that such an initiative would work is if housing prices stabilize and rise over the next five years. This is the same flawed assumption that allowed affordable mortgages to work during the Housing Bubble. Theoretical equity gains from assumed price appreciation were expected to allow adjustable mortgage homeowners the ability to avoid foreclosure.

The proposal assumes that temporarily removing foreclosures from the market will stabilize housing prices. This assumption is preposterous. The presence of foreclosures does drive home prices lower at a more rapid pace than would occur in their absence. But what foreclosures really accomplish is to force the housing market to clear. If houses weren’t overvalued prices wouldn’t be collapsing. Home prices appreciated during the Housing Bubble to unsustainable heights and no amount of government interference will keep them from returning to sustainable valuations.

The government proposal ignores that home prices are not falling solely because of foreclosures. Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s. The supply of houses is higher as there are more vacant homes in the United States than at any time in history. Demand is lower as subprime mortgages are no longer widely available. Credit is tighter and terms more restrictive. Highly leveraged, 100% loan-to-value and low interest rate adjustable mortgages are less prominent. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly. Cultural and social values attached to homeownership are being eroded. Market forces will drive prices lower irrespective of the presence of foreclosures and in spite of government intervention. Foreclosures accelerate the resolution of the overvaluation problem by forcing the market to clear.

As the economy contracts, unemployment rises and home prices continue to fall, more foreclosures will follow. There are millions of economic time bombs spread out through 2012 that will explode into foreclosures as adjustable rate mortgages reset. Once we have bailed out 3 million owners facing foreclosure today, how are we reasonably going to turn down future distressed homeowners? The government will be forced to perpetually bail out mortgage holders as defaults continue for years to come.

Imagine what kind of behavior this government intervention will encourage? Why would anyone who can afford to pay their mortgage do so if defaulting provides access to government-subsidized, low interest rate loans? I am sure that there will be some restraints on the issuance of such loans to prevent widespread abuse, but at the margin the government will encourage defaults.

And what benefit will be produced by such a government program? Homeowners facing foreclosure can not pay market interest rates and have no equity in their homes. If either of these preconditions did not exist, defaults could be avoided. Foreclosures will not be avoided, but simply delayed for five years until government-subsidized interest rates reset. Politicians have recognized the dangers of looming foreclosures. Instead of resolving these structural impediments to an economic recovery, the government appears intent on further delaying the market resolution of these distressed properties to devastating effect.

The market will not forget this government sleight of hand. There will be a persistent negative overhang on housing as every day brings these distressed homes closer to reentering the market. Potential buyers will understand this dynamic and restrain house purchases. And what would happen five years after the plan’s implementation? A dramatic increase in the supply of distressed houses for sale would be harmful to the recovering housing market and economy. The proposed foreclosure bail-out would cause another government created housing disaster.

There are actions that the government can and should take to deal with millions of impending foreclosures. Owners that are appropriate for workouts should actively be engaged for the sake of economic efficiency. Economist John Geanakoplos of Yale has proposed an elegant mechanism for facilitating this process which prevents government distortion but allows homeowners to avoid preventable foreclosures.

The foreclosure process should be streamlined. The legal process takes too long, is expensive and acts to exacerbate and extend the pain of home losses. Every day that a home is navigating the foreclosure process costs the lender money. Neighborhoods suffer blight and declining property values as homes sit vacant and deteriorate. Government should facilitate the foreclosure process, not delay it further.

It would be extraordinarily valuable for government initiatives to resolve the structural foreclosures which are spread out over the next several years. These remnants of the affordable mortgage boom functionally act like economic time bombs and ensure that homeowners will default when interest rates reset. Prior to resetting, the favorable terms of these adjustable mortgages delay inevitable foreclosures because introductory interest rates are affordable. These impending foreclosures should be resolved not further delayed though government intervention.

Regrettably, the housing market is a slow moving behemoth. Its size and glacial pace make it unlikely that overvalued housing prices will be resolved in the near future. As painful as foreclosure driven price declines have been, they have served an important function by accelerating the process by which home prices will reach stable and sustainable valuations. Foreclosures will ensure that an economic recovery begins far sooner than in their absence.

The proposed foreclosure bail-out erects a long-term, structural impediment to a housing recovery. Government intervention which delays the resolution of distressed homes will extend the housing downturn as long as these inevitable foreclosures are kept off of the market. Any government action should be undertaken with a design to facilitate the house clearing process and with an understanding that substantial economic pain resulting from falling home prices is unavoidable.