Let's Bail

The recent sub-prime mortgage bailout plan proposed by the Bush administration touches free-market conservative nerves for a number of reasons. It's an unneeded government intervention in the marketplace with dubious benefits for a select few that shifts responsibility and likely will have adverse long term impacts. Other than that, it's a great plan. In Saturday's Wall Street Journal, there were no less than six letters to the editor decrying the idea.

In today's paper, Alan Reynolds dissects the Bailout Plan (sub req) and finds its underlying premises wanting:

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.

Those who bought homes with no money down have nothing to lose by walking away if they can't resell their homes at a profit. Perhaps that explains why only those with substandard credit ratings are singled out for special treatment under the Bush administration's plan. The "hope now" behind this plan is that people who have good reasons to default will keep paying anyway, even if the value of their houses keeps falling.

Again, other than that, it's a great plan. Reynolds also destroys the notion that there's anything "free-market" about it:

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.

I'm waiting for the day when a politician proposes a bailout plan for those of us who make sound decisions to buy homes that we can afford based on realistic financial expectations and an understanding of the contracts that we VOLUNTARILY enter into. The plan would be simple: no more bailing for us. Call me a dreamer.