In today’s Financial Times Economists’ Forum, Michael S. Barr and Laura D. Tyson present proposal to deal with the problems of the American residential housing market and the housing finance market: “Foreclosures: How to save America’s family equity”.

Under their achingly preciously acronymed SAFE (Save America’s Family Equity) loan plan, the US Treasury and the Federal Reserve would run auctions, in which Fannie Mae, Freddie Mac and Federal Housing Administration originators would purchase mortgages from current investors at discounts determined by the auction process. The FHA, Fannie Mae, and Freddie Mac would work with “responsible originators” to restructure the loans they acquire to stem defaults, foreclosures, and liquidations.

This is a terrible proposal: distortionary, unfair and except in the shortest of short runs so beloved by political opportunists, a threat to macroeconomic and financial stability because of the moral hazard and other perverse incentives it creates for reckless borrowing and reckless lending in the residential home finance markets. The FHA, Fannie Mae and Freddie Mac are, of course, the vehicles through which the US has since the Great Depression pursued its unique brand of socialism for the middle class. This proposal widens and deepens that role and extends it to include socialism for the upper-middle class.

The SAFE plan would slow down the process of the American homeowner and the American mortgage lender getting reacquainted with reality. The reality that Ponzi finance does not work in the long run: when you borrow more and more to buy more expensive assets in the hope and expectation that, without you performing any productive or creative effort, the increase in the price of the assets will allow you to service your growing debt, you will sooner or later come a cropper.

Implementing the proposal would delay the necessary drastic downward repricing of residential real estate, the writing down or writing off of mortgage loans that never should have been made, and the movement of millions of people out of owner-occupied housing they cannot afford ,into either more affordable owner-occupied housing or into cheaper rental accommodation. We need a large fall in US home prices and in the price of residential mortgage-related assets to restore equilibrium. When people have chosen to live in a dream world for many years, waking up is likely to be a bit of a shock. Bringing out the Barr-Tyson laudanum whenever the US homeowner and mortgage lender threaten to return to the real world is not a solution.

The proposed auctions would misuse an intervention designed to handle liquidity crises (and supported by me in that context - that of the central bank acting as ‘market maker of last resort’ in a liquidity crisis) in order to bail out the losers in an insolvency crisis. There is no need for such auctions, either as a price-discovery mechanism or as a vehicle for injecting liquidity in illiquid markets.

There is no problem about valuing the mortgages that would be offered to these quasi-public quasi-fiscal agents. The mortgages are not packaged/bundled non-transparently with credit card debt from North Korea and Iran or with car loans from Cuba, that would be hard to price. There is no lack of liquidity that is holding back lenders. The simple fact is that the issuers of these mortgage-related assets would like to be paid more for them than they know they are worth. And they may get their hoped-for tax-payer funded excess returns if Barr and Tyson succeed in getting their proposal implemented.

The proposal is a classic quasi-fiscal scam, because the subsidies transferred to the mortgage lenders and to the home owners would be off-budget and off-balance sheet items for the Federal government. Only when the assets acquired by the two technically private but de-facto publicly guaranteed agencies, Fannie Mae and Freddie Mac, and insured by the FHA (a government agency) go belly up to an extent not anticipated in the prices paid for them, and not reflected in the insurance premiums charged by the FHA, will the true fiscal cost become apparent. And that could be years from now.

Such quasi-fiscal shenanigans make a mockery of fiscal transparency, accountability and responsibility. It is the stuff beloved of failing governments in weak states - banana republics, unsuccessful transition economies and other examples of states with public sector governance failure. The US should not touch it with a barge pole.

The authors argue:

“But there is nothing normal about conditions in our housing or credit markets today. That’s why we need SAFE to stem the downward spiral of foreclosures and plummeting housing prices that has undermined liquidity and confidence in global capital markets and that threatens a long, painful recession in the US and a global growth slowdown.”

Quite the contrary. Normalcy is finally being restored in the US housing market, in the residential construction industry and in the housing-related credit markets. We have had our Age of Housing Insanity: the decades-long run-up in house prices and construction ahead of demand. It was only yesterday that anyone traveling in the US could see the inexorable building of the the bubble in much of the US housing market, fed since 2001 by economy-wide excessive credit creation, and by a mind-boggling housing-related securitisation orgy and relaxation of credit standards.

As a result millions of people have ended up with houses that, even with prices now falling, are far too expensive for them; and they are saddled with mortgage debt they either cannot service or do not wish to service any longer even though they have the financial means to do so: they have negative equity because of declining house prices - the value of the collateral (their home) has become less than the value of the loan secured against it. The only effective solution to the problem of people living in houses that are too expensive for them is for those people to leave these houses. This can be achieved either by them selling their houses voluntarily or through foreclosure and repossession. There will be millions of such cases because millions of people live in houses they cannot afford and because hundreds of home lenders and millions of borrowers agreed on collateralised loans that can and should no longer be serviced.

Larry Summers has pointed out (Barr and Tyson also make this point) that the foreclosure and repossession process in the US is socially costly and often very time-consuming. Apart from the time and other resource costs of foreclosure and repossession (which can be as much as $50,000 per property), there are the neighbourhood externalities of foreclosure and repossession. This is socially wasteful and calls for two kinds of measures. First, measures to make foreclosure cheaper, easier and faster. Second, measures to prevent the granting of mortgages that are too likely to result in default and foreclosure; the principles are simple: no more mortgage debt that is too large unless the value of the house appreciates; no more mortgage debt whose true cost of servicing is hidden from myopic, uninformed borrowers; no more mortgages for people who are known to be poor credit risks.

Apart from that, all we can hope for is the most rapid possible decline in US house prices to something closer to their fundamental value. According to Robert Shiller this could require average house prices to fall another 15 percent or so. That actually looks like a small number, given the amount of over-building during the past decade and given the bubbly froth on much of the US housing market since the end of the tech boom until late 2006. But whether house prices should fall by another 15 percent or another 25 percent, it is key that they do so as soon as possible, so households, financial institutions and the residential construction industry can plan for the future standing on the solid rock of realistic valuations rather than on the quicksand of false prices propped up by quasi-fiscal interventions of the kind proposed by Barr and Tyson.

To finish, two more pet peeves prompted by the Barr-Tyson boondoggle proposal.

First, Barr and Tyson write: “Only loans on owner-occupied homes would be eligible for restructuring and speculators would be excluded.” Anyone with an open position, long or short, in an asset is a speculator, hoping or expecting to profit from changes in the price of the asset. Therefore, every owner-occupier in the USA who expects to either trade down or trade up in housing over the remainder of his or her life span is a speculator. Until recently, long speculative positions were quite successful. That situation has changed dramatically since the beginning of 2007. It is not a pretty sight to observe well-trained academics who ought to know better engage in populist speculator-bashing. Speculation is a vital, essential economic activity; no market economy can survive without thriving speculative markets. Speculation can be destabilising, as it was in the US owner-occupied residential housing market earlier this decade, but there is no substitute for it. Populist cant may be de rigueur among those jockeying for position in the next Democratic administration. If acted upon it will hurt the US economy.

Second, what is it about owner-occupiers? Every politician, and everyone wishing for a role in Washington’s economic policy circus, wants to put his hand in the pocket of the tax payer to compensate the owner-occupier for losses incurred largely as a result of their own greed and ignorance. Only the mythical family farmer can call on subsidies from the public purse with greater ease. ‘You break it you own it’ is still the golden rule of personal responsibility and a pretty good first pass at a foundation for rules for compensating private sector losers out of the public purse. If there is hardship and poverty involved, or serious externalities, public intervention through regulation or subsidies and taxes may be desirable. But poverty and hardship are not the issue here. The externalities associated with foreclosures and repossessions are more efficiently addressed by making them cheaper, easier and faster.

The Barr-Tyson proposal has absolutely nothing to recommend it. It will no doubt be very popular.

March 3rd, 2008 in Culture, Economics, Ethics, Financial Markets, Monetary Policy, Politics | Permalink