McCain’s bailout: moral hazard or economic salvation?

Today’s topic: John McCain recently proposed that the U.S. Treasury buy up bad mortgages. How would that affect the mortgage and financial crises? Would McCain produce better results than the new Federal Housing Administration program and voluntary industry efforts? Previously, Mitchell and Abromowitz discussed the biggest players in the mortgage meltdown and whether Washington should give tax breaks to homeowners.

Don’t fudge with the free market, John McCain
Point: Daniel J. Mitchell

During the Oct. 7 presidential debate, John McCain proposed to spend $300 billion of other people’s money to buy “bad” mortgages. This is a very misguided proposal. Even if the myriad details were handled correctly, McCain’s “American Homeownership Resurgence Plan” would be a very costly and risky form of intervention.

The campaign argues that falling house prices and economic uncertainty have combined to put some Americans in the unenviable position of having mortgages that are worth more than the value of their homes -- sometimes known as being “underwater.” This certainly is true, though it does not mean that people no longer can make their monthly payments. Nonetheless, there obviously are some Americans who no longer can afford their monthly payments. Moreover, people with underwater mortgages have an incentive to “walk away” from their houses.

While these are genuine concerns, McCain’s cure is worse than the disease. His bailout has several shortcomings:

* The bailout would reward banks and other lenders who did not exercise proper judgment and risk management. If taxpayers are forced to buy bad mortgages, financial institutions -- in effect -- are rewarded for their incompetence. Equally troubling, the bailout would send a signal that banks and other mortgage lenders can be similarly reckless in the future because of the precedent that McCain’s plan would create for further handouts.

* The scheme would punish people who behaved responsibly. Notwithstanding all the trouble in housing markets, most homeowners are not in trouble. These are the people who did the right thing. They saved for a decent down payment. They purchased a house that was within their means. And they have been paying their mortgages. The bailout, for all intents and purposes, would penalize these people by making them pay for the less responsible people who got no-down-payment loans based on the rather reckless assumption that home values would climb every year.

* The plan would encourage people to stop paying their mortgages. One of the most perverse features of the McCain bailout is that the responsible people would suddenly have an incentive to become irresponsible and stop paying their mortgages. There are many American households that are living in homes that are underwater, yet they are keeping their promises and paying their bills. Under McCain’s plan, though, they would feel like chumps for doing the right thing.

* The bailout would reward speculators. Some people saw the housing bubble as an opportunity to make quick profits by buying and selling homes. There is nothing wrong with such speculation -- assuming that the people seeking quick profits (or those financing the speculators) also are willing to accept quick losses. McCain’s bailout would socialize the costs of bad speculation. This is morally offensive, but also economically foolish because it would encourage imprudent levels of speculation in the future.

There are other problems with McCain’s proposal, including the big-picture issue of whether we hurt economic performance and American competitiveness by subsidizing over-investment in housing. What McCain apparently does not understand is that more government almost always is a recipe for making a bad situation even worse.

The bailouts already adopted by President Bush and Congress were bad ideas, and they have not helped the economy. McCain’s mortgage bailout is a bad idea, and it will not help the economy. And the mortgage foreclosure freeze proposed by Barack Obama is a bad idea that will not help the economy (actually, it’s a terrible idea because it undermines the rule of law and is akin to the banana-republic policies that have turned nations such as Argentina and Zimbabwe into basket cases).

It does not matter if bad ideas are proposed by Republicans or Democrats. Policies that increase the burden of government and interfere with the free market lead to negative results. The current financial turmoil is largely the result of misguided government policies such as easy money by the Federal Reserve and corrupt subsidies from Fannie Mae and Freddie Mac. Bailouts of any kind are a further step in the wrong direction.

Daniel J. Mitchell is a senior fellow at the Cato Institute, where he is an expert on tax reform and supply-side tax policy.

Irresponsible homeowners aren’t the only ones hurt by the crisis
Counterpoint: David M. Abromowitz

Dan,

It is good news when a champion of financial deregulation recognizes that government is not always bad and that sink-or-swim approaches only result in more of us drowning. So I welcome McCain’s proposal and his running mate’s description of a huge federal re-write of private loan documents not as “government getting in the way,” but as “a hand up, not a hand-out ... [to] help American families keep their homes and save failing neighborhoods, and bring stability to our housing market.”

Until recently, McCain consistently approached collapsing home prices differently. He seemed to believe it easy to tell good people from bad, scolding last March, “I have always been committed to the principle that it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers.”

After millions of foreclosures -- and with another 5 million borrowers heading that way and house values in free fall around America -- taxpayers and all homeowners are threatened far more by plunging prices thanks to vast oversupply and scared buyers than by the possibility that some undeserving borrowers might avoid the worst. So it is not accurate to say that “most homeowners are not in trouble.” When normal market forces have ceased to function, no house is an island in this economy. Even after credit markets thaw -- which will happen soon, hopefully -- our economy will remain vulnerable if consumers see any remaining home-value wealth continue to vanish.

Don’t get me wrong; as someone still paying his mortgage, I get plenty angry about well-off borrowers who can afford their payments but walk away. After all, the vast majority of riskier subprime borrowers between 2001 and 2006 were mid- to upper-income families, not lower-income families conveniently blamed by those determined to shift responsibility for the meltdown.

The flaw in the McCain plan, then, is not your central complaint, Dan -- that government is doing something at all -- but rather the plan’s specifics. In fact, many of your critiques can be addressed -- McCain could narrow the scope to only owner-occupied primary homes, which would cut out speculators who bought five condos. The plan should also require borrowers who receive assistance to give back something in return. In exchange for a fixed-rate mortgage on terms the individual can afford today, any future increase in property value should be shared with the taxpayers at sale or refinancing (a proposal my colleague Andrew Jakabovics and I outlined early this year).

Perhaps the central flaw in the McCain approach comes from schizophrenia in whether he aims to aid homeowners and neighborhoods or to provide liquidity to lenders. I agree with your critique of unwarranted benefit to lenders who peddled high-risk, high-cost loans. If McCain’s plan would in fact pay off the loan at full value, as his economic advisor said the day following the Oct. 7 debate, it would be the most expensive approach yet toward mortgage stabilization. The major housing legislation passed this summer by Congress more responsibly requires any mortgage refinanced with a safe Federal Housing Authority loan to involve the lender taking a major, painful loss.

During a major housing crisis 75 years ago, Franklin D. Roosevelt boldly created the Home Owners Loan Corp. In doing so, he helped turn around a worsening situation, stabilized communities and even returned a small profit back to the U.S. Treasury. Dan, your laissez-faire-at-all-times approach would have shelved that plan then -- that is not the right approach for America today.

David M. Abromowitz is a lawyer and a senior fellow at the Center for American Progress Action Fund.