The Folly of Mortgage Forgiveness

Alan Blinder's editorial in the October 20 edition of the Wall Street Journal, How to Clean Up the Housing Mess, contains shockingly bad recommendations regarding America's housing hangover from the Greenspan era of easy credit.

For example, Blinder contends, in the opening paragraphs of his editorial,

"Sadly, however, we did almost nothing to stop the predicted foreclosure wave, which is now drowning us. The issue at this late date is how we can mitigate the damage.



One oft-repeated answer comes from the intellectual descendants of Andrew Mellon and Herbert Spencer: liquidate, liquidate, liquidate. Let the housing market find its natural bottom, and the chips fall where they may.


I beg to differ. Some of the reasons are humanitarian. Millions of foreclosures are ruining millions of lives and devastating many communities. We can do better than Social Darwinism."

Blinder refuses to acknowledge that the housing foreclosure mess and overbuilding involved borrowers getting themselves into loans which they should have declined, mostly for houses they could not afford. Simply declaring that they must be spared is a pipe dream. Liquidation of foreclosures doesn't necessarily mean evictions, but we must have an attribution of the loss of value to some party. And that party would, according to mortgage contracts, seem to be the borrowers. If they default and the lenders can't recoup all of their loan value, then they, too, will share some of the loss.

Next, Blinder makes a baldface misstatement,

By now, massive underbuilding during the slump far exceeds the overbuilding during the boom. So, by rights, a shortage of houses should be pushing up house prices, incentivizing home builders, and boosting growth in gross domestic product. Instead, actual and prospective foreclosures hang over the housing market like a wet blanket."

On Monday afternoon, two economists who were guests on Bloomberg television agreed that the recent rise in housing starts is bad news. That the US still suffers from a surplus of housing. So Blinder is wrong to claim that there has been a "massive underbuilding during the slump" that "far exceeds the overbuilding during the boom." If that were true, we wouldn't have a foreclosure dilemma, because demand would be supporting housing prices.

Blinder claims the following regarding federal mortgage relief,



"The first is money. Given the huge magnitude of the aggregate gap between house values and mortgage balances, a comprehensive anti-foreclosure solution requires hundreds of billions of dollars. (Note, however, that this money would be lent, not spent.)"

How does he know the money would "be lent, not spent?" Losses will eventually have to be realized, which means 'spent' money which artificially paid for value that just isn't there.

"The second barrier is a host of legal complications—stemming from such things as securitizations, second mortgages, and the like—that make it difficult to design and execute a comprehensive plan. The details would put you to sleep. But the bottom line is that most serious solutions entail modifying somebody's property rights—which is something we don't do lightly in America, and for good reason."



So Blinder doesn't take this lightly, but, what the heck, let's do it anyway. We'll just say, you know, that we 'didn't do it lightly.'

"The third barrier may be the biggest: politics. Apparently, many Americans view it as unfair to bail people out of unaffordable mortgages. Do you remember the famous Rick Santelli rant on CNBC in February 2009—the one that gave the tea party movement its name? Mr. Santelli was griping about President Obama's new foreclosure mitigation programs—the ones I just characterized as half-hearted. It would have been a brave politician indeed who pushed to make those programs larger and more generous.
Most economists see principal reductions as central to preventing foreclosures. That takes money, of course—plus ignoring the Rick Santelli rant. Perhaps the cost to taxpayers could be reduced by giving the government—or even private investors—some of the upside when house prices finally start climbing."

For some reason, perhaps because he's a liberal, and Rick Santelli is not, Blinder delights in demonizing the CNBC on-air staffer. Calling the process of saddling taxpayers with the losses of injudicious borrowers for homes they could not afford "politics" is a convenient way to disguise and endorsement of moral hazard, as well as bad policy.

"Many vacant houses could be converted into rental units by enterprising developers. The government could make such investments more attractive, e.g., by using mechanisms similar to what the Federal Reserve and the Treasury did during the worst of the financial crisis. Back then the government lent money to investors who were willing to buy mortgage-backed securities; this time it could lend money to investors who are willing to invest in certain rental properties."




Ironically, Lew Ranieri complained on CNBC earlier this year that such federal loan programs for small investors, which were a key part of the 1980s S&L crisis recovery, were not offered in the most recent mortgage-related crisis. Once again, though, one has to ask, who will have born the losses on these houses as they return to the market at lower prices?

Blinder is all for mandated loan forgiveness, forgetting that such losses will make banks take losses, further imperiling their capital adequacy. Large US banks wouldn't even be at the table discussing the issue, had the federal government not intimidated them with baseless litigation as the price of declining to join the talks.

As I explained to a friend the other day, housing value losses are a fact. There are only three groups which can absorb them- homeowners, banks and taxpayers. Blinder wants banks to absorb the losses. That will, as I have explained in this piece, cause capital adequacy issues, as well as reward borrowers for taking excessive risk. If homeowners are left to follow available legal options, including bankruptcy, then housing prices will fall to market-clearing levels and others who can now afford such houses will buy them. If the government, either directly or through GSE pass-through securities, assumes the losses, that means, in effect, taxpayers are bailing out homeowners.

That's no way to treat a private sector, nor to resolve the US housing problems. Blinder's ideas for dealing with the housing sector's woes and coming foreclosure boom should be ignored.