The Pain of Principles

I signed papers today to refinance my mortgage, for the purpose of improving my cash flow so as to be more financially agile in case the unexpected should occur. In an exchange of views, the title agent, an extremely nice and competent lady, encouraged me to consider the plight of homeowners like her husband and herself: They purchased six years ago, and have a thirty year mortgage at 5.75%, but currently owe $100,000 more on their mortgage than their property is worth in this market. They have been responsible borrowers, and always paid on time, but now find themselves, through no fault of their own, unable to sell their home or refinance at today's lower rates. What do I say to her?

The accompanying graphs from zillow.com illustrate the decline in home values in my metropolitan area over the last ten years. I suspect the actual decline is somewhat larger, as the latest appraisal from my own home erases a decade's worth of appreciation (the horizontal line in the bottom image). The significant information is the bar graph in the top-left image that shows the negative equity that burdens people who bought in the middle years. Again, based on my own home, I think the negative bars should be larger, and occur in more years. Is it unreasonable to deny help to honest people caught in these circumstances?

This is not a matter of personal responsibility in that many of these people were not irresponsible. These people were just unfortunate. Does it make sense for the government to assist them, in offering loans with over 100% loan-to-value ratios, in subsidizing lower interest rates, in subsidizing mortgage payments? Charity dictates that we help, but our constitution denies us the ability to use the coercive power of government to force us to help:

I cannot undertake to lay my finger on that article of the Constitution which granted a right to Congress of expending, on objects of benevolence, the money of their constituents.

President James Madison, 1794

I cannot find any authority in the Constitution for public charity. [To approve the measure] would be contrary to the letter and the spirit of the Constitution and subversive to the whole theory upon which the Union of these States is founded.

President Franklin Pierce, 1854

I can find no warrant for such an appropriation in the Constitution, and I do not believe that the power and duty of the General Government ought to be extended to the relief of individual suffering which is in no manner properly related to the public service or benefit.

President Grover Cleveland

It is difficult to disappoint people. Especially good people whose approval we desire. But people in this situation cannot be made whole without the crude redistribution of wealth. The most efficient remedy is still to encourage a rebound of the economy, which will naturally reestablish the demand for homes, and raise home prices. Direct aid of the type proposed by the Obama administration creates an undeniable moral hazard, which only encourages repetition of the behavior that caused this problem, and which will only make the problem worse.

It is easy to have principles when they cause us no pain. It is much more difficult when we also feel the pain they require.

Update: Business Week makes an argument to assist "upside down" homeowners in The Risk from Underwater Homeowners, saying:

Many homeowners owe more on their mortgages than their homes are worth, and—rightly or wrongly—increasing numbers of them may decide to give up and mail in the keys.

The most effective way to keep underwater homeowners from walking away en masse would be a big writedown of the principal they owe.

Writing down mortgage debt on houses that are underwater could total $1 trillion or more. The value of underwater homes could be as much as $700 billion below the mortgage values, according to financial analysts and informal government estimates.

"If your house is worth much less than the loan, you're pretty sure you'll never really own it. You'll just go rent somewhere. The only bad thing is the mark on your credit rating, which for these people wasn't too good in the first place."

The default rate is about nine times as high for people who are way underwater as for people with substantial equity in their homes...

The argument seems to hinge on the notion that if homeowners are going to default anyway, lowering their principle as a way to keep them in their homes keeps the house from going vacant and losing even more value. But it seems undeniable to me that this creates both an immense moral hazard by inviting homeowners to threaten abandonment to receive substantial writedowns, and creates such a disincentive to lend that lenders will substantially raise interest rates to cover their losses from all the writedowns. If the government steps in to prevent interest rate hikes, lenders will sit on their money, and if the government funds mortgages directly without compensating rate hikes, it exposes the taxpayers to paying the full cost of both past and future defaults.

If government is flirting with the idea of re-writing contracts to solve the "crisis", how about re-writing the contracts to make them recourse loans - so that lenders can seek to recover their losses from homeowners who voluntarily decide to walk away from mortgages they can afford to pay? In return, the borrower would receive a partial writedown. If we, as taxpayers, are being asked to share the pain of "underwater" homeowners, it doesn't seem fair that the solution should relieved them of all of their pain. They should pay a price for our assistance, and remain "on the hook" for some of their losses. After all, they are the ones who signed those loans.

Update: And yet another rejoinder, this one from Francis Cianfrocca in the New Ledger: Winners & Losers in Obama’s Mortgage Fix. Here are the money lines:

I think the proposal is intended to directly supplement mortgage payments for millions of people (using the 31%-of-pretax-income benchmark for mortgage affordability). There are reports that the plan will somehow facilitate refinancings at lower interest rates, which is somewhat similar in effect. If I’m right, this is effectively the same as reducing people’s mortgage payments (but not their mortgage principal amounts) to a level that reflects current market reality.

But at the same time, it keeps lenders from having to suffer the effects of that reality. This proposal sharply increases the value of existing mortgage-backed securities by sharply reducing their implied default risk. It directly transfers value from taxpayers to the owners of mortgage-backed securities.

The net effect is that we’re PERPETUATING the housing bubble by disallowing the market to clear at lower price levels. (The economic counterargument, which is not unmeritorious, is that allowing the market to clear will precipitate a deflationary spiral and a replay of the Great Depression.)

$75 billion is ordinarily a lot of money. But in this silly season, it actually isn’t a lot of money to throw into an economic imbalance that affects the whole country. If that’s all we’re going to spend on this, it’s not bad. It will allow a few unscrupulous homeowners to screw the taxpayers, and it will make Obama look good, but it won’t seriously change the economic situation. This all by itself is positive for bankers, because they’ve been uncertain whether they were the ones the Administration would try to screw.

If the program proves popular, however, look for it to expand. And if that happens, look for the fortunes of the homebuilding industry to recover.

This sounds good, but it’s very evil. We have far too much housing already in this country, the residue of the last housing bubble. If we get another one now due to government deliberately overvaluing mortgages, we’ve set the stage for yet another nasty crash in some future year.

And next time, it won’t be homeowners who will be overextended. It will be the taxpayers.