Thrifty Thinking

February 26, 2008

Dean Baker
The Guardian Unlimited, February 25, 2008

See article on original website

The bankers are on the offensive again, demanding hundreds of billions of taxpayer dollars to protect them against their massive losses on bad mortgages. They have hostages this time. They claim that millions of low- and moderate-income homeowners will lose their homes if we don’t meet their demand.

Before we let our representatives in Congress surrender, let’s look at this situation with clear eyes. The basic story is that millions of homeowners now owe more on their mortgage than their house is worth. This is due to the fact that the $8 trillion housing bubble is now collapsing – apparently the geniuses who run the banks somehow managed to overlook this bubble.

Underwater mortgages lead to foreclosures for two reasons. First, homeowners can’t borrow against equity to make their mortgage payments in bad times. The second reason is that a homeowner with negative equity has a strong incentive to simply turn his house over to the bank, relieving himself of a debt that is worth more than the value of the house. While the latter type of foreclosure may actually be good for homeowners, it is clearly bad news for the banks, which take a big hit in the process.

The bank bailout crew want to stop the bloodshed on Wall Street by having the government step in and either guarantee or buy up the bad mortgages. The government is then supposed to ensure that the homeowners get new mortgage terms that allow them to be able to stay in their home.

Apart from the bureaucratic complications inevitable in such schemes, this is an incredibly bad deal from everyone’s standpoint except the bankers. This can be easily seen by examining the bailout scheme developed by the Office of Thrift Supervision (OTS), which has received considerable attention recently.

Under this scheme, in the case of underwater mortgages, the government would guarantee a new mortgage reflecting the current value of the home, but the homeowner would still be obligated to pay off the full value of the original mortgage when they sell their home, if the price is high enough. In other words, the OTS scheme virtually guarantees that the vast majority of homeowners who “benefit” from its plan will never have a dime of equity in their home.

While the OTS plan does call for workout arrangements that are supposed to make the mortgage affordable to homeowners, in the vast majority of cases homeowners are likely to find that they are still paying more for their mortgage, taxes, repairs and other related expenses than they would pay for renting a comparable unit. In other words, homeowners will pocket no money when they sell their home and they will pay more than necessary in housing expenses for each year they live in their home. This is truly social policy made in Washington.

But wait, it gets better. In the OTS zero equity world, defaults are likely to continue at a rapid pace. Let’s say that 20% of the new loans end in default and that the average loss on the homes foreclosed is half of the value of the mortgages. If an average mortgage is $200,000 (the example used by OTS), this makes for a loss of $100,000 for each foreclosure.

Put another way; let’s assume that 30% of the homeowners in this programme would have held onto their house in any case. If this is the case, then just half of the homeowners in the OTS scheme would actually be keeping their home because of the plan (20% default anyhow and 30% would have held onto their home without help). This means that taxpayers will have to cover $200,000 in loses (two foreclosures) for every five people helped, a tab that comes to $40,000 per homeowner.

Consider that it costs $3,000 a year to provide a kid with healthcare and $5,000 to pay for childcare. In this world, it doesn’t sound very smart to pay $40,000 to allow a moderate-income family to stay in a house where they accumulate no equity and blow money on mortgage payments.

Oh yeah, but I forgot about the bankers. Every dollar lost by the taxpayers covering the cost of foreclosures is a dollar in the pockets of the bankers (minus the administrative costs of the programme). The homeowner rescue schemes developed by the OTS and others may not do much for the homeowners, but they will help bankers in real need.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer ( He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues. You can find it at the American Prospect’s web site.

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