Tracking TARP

Elizabeth Warren, the bankruptcy specialist who issued a report on where the funds are going, did an interview with Terry Gross yesterday.   Warren is basically a consumer advocate, and so much of the interview expressed her indignation that the fund is focusing on keeping banks afloat, but not attending to the problem of foreclosures.  Warren is eloquent, if somewhat hyperbolic, about the tragic consequences of a wave of foreclosures on both the foreclosees and their neighbors.

How easy it is to address foreclosures, however, depends on what the reason is for the foreclosure.  Are people missing payments because changed circumstances mean that they can't afford them, or are people missing payments because they don't want to make payments on a house that was worth $500,000 when they bought it, but is now worth $300,000?

That's actually a complicated question, because many people bought a house they couldn't really afford on the assumption that rising markets would give them the equity to refinance into a mortgage they could afford.  This turned out to be a bad bet.

But people with ARMs are not, by and large, actually in the position of having suddenly seen their interest rate jump by double-digits.  They're in the position of having seen their interest rate go from a low teaser to a still pretty low adjustable rate.  The interest rate indices generally used to set ARM payments are actually quite low right now, though of course, the rates are often lagged.  Still, the problem is not that people got caught out by surprisingly high rates.

That leaves us with two questions:  how low a rate are we willing to provide in order to produce a workout?  And what if the problem is, as even some liberal commentators are arguing, that people don't want to make payments on a house where the value has dropped by half?

I don't think that the US government can provide price protection against falling home values, for several reasons.  The first is the moral outrage.  It's one thing to help people who got caught out by bad life circumstances by reducing a crushing interest rate, especially when the government has, as now, such low borrowing costs.  It is quite another thing entirely to simply give someone tens of thousands of dollars in home equity on an unaffordable house they bought without any substantial downpayment.  Are those people going to be allowed to profit from their heavily subsidized houses if the market recovers?

People who bought homes they could afford, or people like me who rented because they thought housing was in a bubble, won't stand for it.  Especially since propping up those peoples' home values will not only require substantial tax contributions from me, but also make it harder for me to buy a house. 

But the other reason I don't think the government can deal with the falling equity problem is the sheer magnitude of it.  Check out this graph, which I stole from this site:

The dotted green line is my contribution.  It suggests that there's a small rising trend since 1975, but that if houses revert to (optimistic) trend, the average price needs to fall back towards and inflation-adjusted $175,000.  That means at least another 15% price drop is in order.

Now for a less optimistic assessment:  look at house prices since 1890

Again, the green lines and the associated commentary is mine.  What if we assume that the last major innovation in the housing market was the long-term amortizing mortgage, and that prices have to return to that trend?  That suggests an average of around $125,000.  Which means that house prices need to fall by about 40% to get back to their normal value.

Is that crazy?  Well, let's ask this question:  what happened in 1997 to make housing worth so much more?  You can't even blame credit scoring and securitization, which became big trends earlier in the decade.  It looks like a big, fat, credit bubble.  And while the government can manage the decline of a bubble, it can't keep us all collectively insane forever.

But say that credit scoring and securitization did make our houses worth somewhat more--say, $150,000 by enabling mortgages to new borrowers and thus expanding the market.  Let us further assume that the financial reforms we are being promised do not involve effectively outlawing securitization. That still leaves us with a long, long way to go.

Is the government going to guarantee approximately 70 million owner-occupied homes in America against a 25% price drop?  No, because that's $3.5 trillion dollars, if my mental arithmetic serves.  Or is it only going to give the money to the least responsible homeowners:  the ones with small (or no) downpayments, houses they could only afford at short-term teaser rates, and a long string of missed payments?  The numbers, and the political arithmetic, don't add up.  Indeed, any such program would positively encourage people to default, in order to get the government to cram down their loans. 

Perhaps the government could work out some program that allows shared participation in price appreciation after a cramdown, but I fear that would simply encourage people to get the cramdown, then sell into the down market--creating exactly the cascade that people are worried about with foreclosures. We may have found an industry that's too big not to fail.