Tuesday, December 11, 2007

Voluntary Sub-prime Bail-Out is Still a Bad Idea

Last week the White House announced a new voluntary sub-prime bail-out. Under the terms of the program, lenders would voluntarily freeze interest rates on certain ARMs for a period of five years, thus preventing them from resetting and probably averting a large number of foreclosures.

The program only covers home buyers who live in their homes, thus shutting out speculators. Also, it is only applied to those borrowers whose loans are in good standing and who are able to continue to meet their mortgage obligations at their current levels. It could have been much worse. Government could have used tax-payer dollars for the bail-out, or they could have chosen to ignore the free markets completely and legislated the bail-out into existence. As it is, the bail-out is a voluntary program by lenders.

Seemingly, this is a free market solution. Lenders are freely choosing to amend their contracts with their borrowers. Nevertheless, I am still opposed to the bail-out. Why so? Lenders and borrowers completely misjudged the risk of sub-prime loans. If priced correctly, sub-prime loans would have been much more expensive, and hence fewer borrowers would have been able to take them. The excess lending caused real estate prices to appreciate to untenable levels. Now that the bubble has burst, mortgage defaults and foreclosures are driving down home prices to their true market value. By "subsidizing" sub-prime loans, the bail-out will provide artificial price support to home prices, and will not allow them to reach their realistic free-market levels. In this way, the bail-out is creating conditions equivalent to price fixing. Since the interest rate freeze is only temporary, the true effect will be a lengthening of the sub-prime crisis and a drag on home prices and on the economy for years to come.

Yes, the unwinding of the home price bubble is painful, but bail-out efforts will only lengthen and defer the pain, not avoid it. This reminds me of the story of the dog owner who needed to surgically remove his dog's tail for medical reasons. Because he felt sorry for the mutt, he decided rather than to cut the tail off with one fell swoop, to only cut a small piece of the dog's tail every day... Doesn't make a lot of sense? Neither does a sub-prime bail-out.

4 comments:

frugal zeitgeist said...

Totally agree. A bailout is a horrible idea; it only artificially props up home prices.

Traciatim said...

This solution however will spread out the problem over a few years and thus make home prices stagnate in certain areas due to some relief. I think it's better to spread the problem over a few years and have the home prices stagnate for a while while inflation catches up a little bit. After that it will be back to business as usual with inflation based real value increases . . . unless of course banks get greedy again. Banks . . . Greedy? Never. We'll be safe for decades!

Shadox said...

Traciatim - that's exactly the point. Instead of taking the pain and dealing with it all at once, this episode will be drawn out over years. Economically, it would have been better to take all losses up front and then return to market growth. Cutting a small piece of the dog's tail each day is not being kind, it is simply extending the misery.

Armchair Fiduciary said...

Shadox - If you are a true free market guy you should think the bailout is fair. Afterall, the mortgages companies are only agreeing to it becuase they think it will be better for them from a $ perspective. Foreclosures typically only recover something like 60% of the value of the home so these lenders are betting that they will give enough people enough time to hang on that they'll actually lose less than letting the people go bankrupt. I agree with your point that this will extend the housing price correciton a bit. Finally, I'd just like to point out that mortgage adjustments have always been available. The politicians just got involved so they could take credit for finding a "solution." This bailout was always there behind the scenes.