This is shocking:

The Obama administration will announce a major new stock market initiative on Friday that will directly tackle the problem of the millions of Americans who lost money betting on stocks. The government will buy loans from stock brokerage houses at the current value of the stocks in an investor’s portfolio, in an effort to stabilize the stock market, people briefed on the plan said. The government will also increase incentive payments to stock brokers who loaned on margin to their investing clients and now assume some of the losses of those clients. And it will require those stock brokers to cover some of the losses of unemployed investors for a minimum of three months.

OK, I made that up. But how is it different from this, which is real?

The Obama administration will announce a major new housing initiative on Friday that will directly tackle the problem of the millions of Americans who owe more on their houses than they are worth. The government will buy loans from investors at the current value of the house in an effort to stabilize the market, people briefed on the plan said. The government will also increase incentive payments to lenders that cut the principal of borrowers in modification programs. And it will require lenders to cut the monthly payments of unemployed borrowers for a minimum of three months.

The Administration is using tax dollars to subsidize some homeowners who are underwater on their mortgages. Today they are beefing up two housing programs with more money.

These programs are targeted at homeowners who could almost but not quite afford their mortgage. The idea is that, with some taxpayer subsidy, their lender will agree to reduce or delay some mortgage payments.

Who is eligible? Under one program, called HAMP, the Home Affordable Modification Program, you are eligible if you:

… live in an owner occupied principal residence, have a mortgage balance less than $729,750, owe monthly mortgage payments that are not affordable (greater than 31 percent of their income) and demonstrate a financial hardship. The new flexibilities for the modification initiative announced today continue to target this group of homeowners.

Excuse me? We’re going to subsidize someone with a mortgage balance of $700,000?!

(Updated: A knowledgeable reader thinks my 5.25% interest rate was unreasonably low, so I’m changing the example to assume a 7% rate.)

Let’s do a quick back-of-the-envelope calculation. Suppose you have a mortgage balance of $700K, with 28 years left on your 30-year mortgage at a fixed 7% 5.25% . Your monthly mortgage payments would be almost $4,800. If that’s greater than 31% of your income, you make less than $186,000 per year.

Does it really make sense for the Administration to use taxpayer funds to subsidize someone making less than $186,000 per year to stay in a home with a $700,000 mortgage balance?!

We further learn the Administration intends to spend $50 B of TARP money for these initiatives.

The Administration argues their goal “is to promote stability for both the housing market and homeowners.” Stability sounds good. The risk is that instead of solving the foreclosure problem, these policies may just prolong it. (The same could be said of some housing initiatives we did in the Bush Administration.) A core housing policy question is whether it’s better in the long run to buy time for struggling homeowners in the hope that they and the housing market will eventually recover, or instead to just rip off the band aid as quickly as possible. Allow the housing market to adjust quickly by not trying to create artificial “stability” above a market-clearing price. Such an adjustment would be excruciating in the short run, and painful for many who would lose their homes. But like ripping off a band aid, it would get all the pain behind us, so that things could return to a normal and more stable growth pattern going forward. I don’t have the answer to this question, but I do get nervous with those who confidently assert that they can create stability, and that they know the right price at which stability should be maintained. Every little kid knows there’s less total pain if you rip off a band-aid quickly. The same may be true here.

Buying a house is a big deal. So is getting a mortgage. As with any investment, when you buy a house and a mortgage you assume both upside and downside risk. You are responsible for both sides of that bet, not someone else.

Some homeowners were fooled or deceived into buying a bad adjustable rate mortgage (ARM). I feel bad for them and am willing to consider policies directed at them. At the same time, it’s hard to distinguish “fooled or deceived” ARM buyers from “savvy speculator” ARM buyers, so if we subsidize one we may end up subsidizing the other as well.

But now let’s look at a homeowner with a fixed rate mortgage who is “underwater” because his home has declined in value so that the house is worth less than the mortgage. His net worth has declined because the value of his home plummeted, and that’s tragic. But since he has a fixed rate mortgage, his monthly mortgage payment has not changed. The decline in the value of their home has not affected his ability to make his mortgage payment, and therefore to remain in that home.

He can continue to live in his home and wait for the value to appreciate, just as a stockholder can hold onto a stock after a decline and wait for the price to recover. I don’t see why taxpayers should subsidize him because he lost money on an investment, just as taxpayers shouldn’t subsidize him if he lost money in the stock market.

This homeowner may face some other financial hardship (see the underlined language above). Maybe he lost his job, or maybe he got hit by a bus and has high medical costs. This financial hardship may cause him to be unable to make his mortgage payments, and with the lost equity value, he cannot borrow against the value of his home. But again, this is no different than if he lost big in the stock market and then lost his job or got hit by a bus.

Imagine twin brothers, each with $180K of annual income. One rents, and the other has a $700,000 mortgage on a home that declined from $800,000 in value to $600,000 in value. Both brothers lose their jobs. Why should the renter pay higher taxes to subsidize his brother’s mortgage payments?

Losing a home due to financial hardship is tragic. Does that make it someone else’s responsibility? Why should a broad-based decline in housing prices shift responsibility for planning for a financial loss from a homeowner to taxpayers? Why do policymakers (on both sides of the aisle) think we should make taxpayers (some of whom struggle to make their own mortgage payments, and others of whom rent housing) subsidize someone who lost money on an investment?

I would like to hear a sound and compassionate policy argument that addresses my twin brother example. To make sure your argument works, please assume there is also a triplet brother who also rents but recently lost $200,000 in the stock market, and explain how your policy applies to him.

My conclusions:

  • I would not use tax dollars to subsidize homeowners with fixed rate mortgages. It’s unfair to the taxpayers, those who rent, and those who might want to buy a home. It also slows down painful but inevitable housing market adjustments. I would treat a loss on a home’s value the same way I would treat an investment loss in the stock market. Both are private responsibilities of the investor.
  • I would be willing to use some tax dollars to subsidize a subset of those homeowners who were fooled or deceived into buying bad adjustable rate mortgages. I would subsidize only the ones who, with a little taxpayer assistance, could afford to keep their home. The hard part is determining who was fooled or deceived. This subsidy would apply only to bad ARMs made in the past and therefore would not be designed as a permanent program.
  • My solution would probably mean more foreclosures in the short run and more rapid housing price declines. I think it would also mean housing markets would adjust more rapidly. My goal would be to allow housing markets to adjust to their market-clearing levels as quickly as possible, based on the logic that this both minimizes total pain and gets it behind us.
  • My recommendations would depend heavily on the numbers. Based on the numbers I saw in 2007 and 2008, in all of these policies the taxpayer subsidies per foreclosure avoided are huge. In addition, since it’s hard to distinguish empathetic cases from savvy investors who were placing bets, a significant fraction of the subsidies goes to people whom I believe do not deserve help. Both quantitative factors reinforce the principles that drive my conclusions.

(photo credit: Flood in East End of Cincinnati – 1913 (LOC) by Library of Congress)