Should taxpayers subsidize underwater homeowners?

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)

I escaped Washington, DC and now teach at Stanford's Graduate School of Business.

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Posted in budget, financial, housing
46 comments on “Should taxpayers subsidize underwater homeowners?
  1. Steve says:

    This move is so unfair. I lived in a home worth less than $400K because I didn't want to speculate in the housing market. Someone like me could've chosen to over-extend his credit and buy a $700K house with $10-20K downpayment. If the home price continued to go up, he would make a lot of money. Now he is losing money and he should declare insolvency. But our wonderful government is coming out to save him. This is absurd like hell. No wonder Charlie Munger said this nation is becoming a big casino. Government is the largest operator who wants to keep the game going. Nobody is talking about market economy anymore?

  2. Shane says:

    So let me get this straight, the plan is to "stabilize" still-artificially overpriced housing? I have given up on the idea that anyone would ever take seriously the moral hazard argument again (though I appreciate you reiterating it). But what about basic economics?

    Do you think anyone at NEC/CEA/Treasury second-guessed this policy just a little bit when they saw these numbers out of Florida?

    Or do they just not get it?

    I guess I'll hold onto my money for another year until the Administration's economists decide its OK for prices to reflect the actual market…

  3. ESM says:

    Another great article Keith. For the life of me, I can't understand why trying to stem foreclosures with government money even works politically. There are far more voters who are responsibly paying their mortgages or renting than there are who might be helped by these programs. And there are probably many responsible renters who would like home prices to drop more so that they can actually afford to buy a decent home.

  4. ESM says:

    One quibble I have with your post is that you imply that perhaps there should be an exception made for ARMs. Well, interest rates are so low now that payments on ARMs are actually more manageable than those on fixed rate loans. The reason why ARM loans are performing far more poorly than fixed rate loans has to do with selection bias at origination. Only the borrowers who were stretching the most or were speculating and wanted the most leverage took out ARMs because of the low initial rate and interest only period. But interest rates have dropped so much, that many of these ARMs have interest rates below where they were at origination. Even the negative amortization, "option ARM" loans — the ones with the 1% teaser rates — have minimum monthly payments today which are only modestly higher than during the initial teaser period. And because the rates on option ARMs are indexed to 1yr T-bill yields (about 40bps), they average well below 4%. In fact, I did a calculation last month and almost nobody who has a negative amortization loan is even negatively amortizing any more (assuming they make the minimum monthly payment), even before the 5 yr recast.

  5. Fred Hyman says:

    A good article and I agree with most of it. I would comment on your conclusion that a loss in a home's value should be treated like a stock. Bear in mind that losses on stocks can be used to offset gains and this is not allowed for losses on personal homes. Thus the comparrison is not totally accurate.

  6. Paul says:

    The premise about ARM=bad is wrong. Anyone with an ARM will be currently experiencing low payments given that the rate moves on the LIBOR which is at historic lows.

  7. […] This post was mentioned on Twitter by C.E.H. Wiedel and Rob Parham, Keith Hennessey. Keith Hennessey said: Should taxpayers subsidize underwater homeowners? […]

  8. If the taxpayer is supposed to give money to people who were "fooled or deceived", then why not give to people who are robbed or conned in all the other ways in life, and the ones whose house burned down or was flooded without insurance, or who put too much money into the bubble stocks in 2000, or who were bitten by the neighbors's dog (through no fault of their own).

    A good political reason for giving taxpayer money to people with high incomes, is that they will thankfully give money to Obama's re-election. He needs money as well as votes to be re-elected.

    According to Obama's economic team, spending this money is all good. He says that every $100 of tax money given to a good cause (or really any cause) produces $150 in wealth, somewhere, sometime, down the road. So, this is a twofer. Help the stupid rich guy, and get a 50% return on the spending.

    If you believe this rubbish, then Let's Counterfeit Our Way to Wealth

    Why does anyone take Obama seriously? Why isn't he a subject of laughter and derision at this point?

  9. […] Should taxpayers subsidize underwater homeowners? […]

  10. Jeff says:

    How is it legal to use TARP funds as a roling line of credit ? The law created TARP as a loan program that was to be paid back and the payback is legally required to be returned to the Treasury. On paper it was never intended to increase the debt (assuming all was paid back).
    This is simply against the law … but apparently not for The Won …

    • TARP is structured as a limitation on the amount that can be loaned out (or spent) at any one point in time. It works almost exactly like a rolling line of credit.

  11. William says:

    I am really, REALLY upset that the gov't is doing this. IT GALLS ME. I don't know what to do. I save my money, I do the right thing, I DON'T ACT STUPID WITH MY MONEY. Why am I and everyone else who reads this blog paying the price? This is so bad. So bad. Make the banks take the pain. Make 'em all go away. What a bunch of thieving jerks. I am so upset. Thank you for listening. Sorry.

  12. […] a comment Go to comments Fair if somewhat provocative (ok, more than somewhat) assertion made here… The Obama administration will announce a major new stock market initiative on Friday that […]

  13. […] (This post appeared on the author’s blog. Keith Hennessey is the former director of the National Economic […]

  14. YooDman says:

    Sounds like another stealth taxpayer funded bailout for the banks. Give the banks another 15 cents on the dollar via the 'principal reduction' for their worthless securities.

    Sure sounds equitable to me in 'dealing' with the housing / mortgage mess … taxpayer funded bailouts of large banks while banking execs get fat bonuses and record salary compensation to compensate for 'reduced' bonuses … taxpayer funded bailouts of reckless, fraudulent, or uneducated / inept 'homeowners' / lenders through modifications which now include principal reduction … delinquent 'homeowners' now turned squatter, not making a mortgage payment for well over a year, just so the banks don't have to 'recognize' the loss on their balance sheet … strategic defaults on commercial real estate (Morgan Stanley walking away from 5 large properties in the San Fran area) … 'do as I say, not as I do' ….


    Trust in the system has evaporated. Trust is THE KEY ingredient necessary for economies and societies to grow … let alone a fiat monetary system to function (which is now being revealed as a complete joke).

    Bottom line. The underlying disease is debt deflation. The usually prescribed ‘medicine’ of ultra-cheap monetary and liquidity inflation will NOT work this time. REMEMBER, it takes two parties to CREATE CREDIT in our system … someone willing/able to provide credit (The Fed … lender of last and only resort now), and someone willing/able to take/accept the credit/loan. Last I checked, credit continues to shrink across all segments except for government. Until this country addresses the massive underlying structural cancer (too much debt to GDP, crony capitalism, socializing losses while extracting profits for the oligarchy) in any meaningful manner, we will not have a meaningful recovery.


    The capital markets have morphed into such an unrecognizable beast over the last several decades … what a sham … I mean shame.


    But don't worry, the US taxpayer will bailout everyone …. UNLIMITED?!

    As Shahien Nasiripour notes:

    Taxpayers have pumped more than $125 billion into the failed firms — and on the hook for many more after the administration promised an unlimited source of funds just before Christmas to backstop their growing losses.


    I rest my case. More looting to come at the expense of US Taxpayers.

    Corzine Plans to Make MF Global Into Treasuries Primary Dealer

    • JayDickB says:

      You got it right. Typical statist BS. "We're trying to help the less fortunate" (but don't look too close at the bailouts to our capitalist friends or the punishment of our capitalist enemies). Does the word fascism come to mind? Chrony capitalism maybe? Always look for the statists' hidden agendas.

  15. courtkel says:

    The paradigm shift needed to address the address the issues you raise requires recognition that as Nowak has shown in his work on networks, punishment is not always the optimal strategy. But beyond moving the paradigm that conservatives are loath to do your consistency arguments are weak. Homeowners receive a mortgage interest deduction, yet renters do not receive an interest rate deduction on their rent payments. Why should taxpayers subsidy one group and not the other? There are many other examples. Policies that "forgive" principal may be rigorously shown to be an optimal response just as creating the ownership society was capable of being modeled as the best outcome. Pimco and Amherst Securities are not hotbeds of radical thought, but both have leaders who agree that principal reduction is the only way out of this mess.

  16. […] economic policies aren’t going to help put people back to work anytime soon, and because the federal housing program subsidies help more than just the less fortunate. Plus, this creates another backwards incentive by penalizing those who manage their money […]

  17. jeanneb says:

    The "brothers" scenario represents one kind of moral hazard. Here's another:

    Homeowner took out a $150,000 equity line on his primary residence to buy a vacation cabin. The cabin has no mortgage.

    Now his company has eliminated overtime. He counted on that to make his payments. The primary residence is now underwater. He's 3 months past due on the first mortgage, 2 months on the equity line.
    (Upside: he spends a lot more time fishing up at the lake!)

    Now taxpayers are told we must bail him out. DOES HE GET TO KEEP THE LIEN-FREE CABIN?

    THis is the kind of inequity we get with one-size-fits-all "solutions".

  18. Not sure the stock market is a good analogy. Stock's inherent liquidity means it can be sold. Margin limits prevent someone from owing more then their stock is worth. When someone's upside down on a mortgage they could walk away. Abandoned houses means no one is making any payments. No one is upkeeping the house which can lead to further drop in value for the neighborhood.

  19. marty says:

    the thing I find most frustrating is the utter inability of the political class to understand how they create incentives that modify behavior, and that in the end people's behavior will be nothing like what they assume it to be, after they have changed the rules. And then they get all upset and self-righteous about people doing what is in their rational self interest.

    Of course, we the people keep electing these creeps because they tell us 2+2=5, so it's our fault in the end.

  20. Eric says:

    Dear Keith,

    This is a difficult question. I appreciate your take on it but think your analogy to stocks and frame of fairness obscure too much. "Fairness" is always an issue. It drives, and should drive, much public perception about public policy. But as is clearly and necessarily the case in market outcomes, widespread benefits come from inequitable distributions of government goods.

    As has been pointed out, stocks are far more liquid than housing. More importantly, housing is not primarily (this might be wishful thinking) an investment vehicle. Foreclosures have significant effects that mean that the owner who has lost value will bear the entire cost.

    Moral hazard is a cost, but it shouldn't be the only consideration. I am not convinced this is a good policy, but I think it needs to be discussed in a more appropriate, less accusatory way.

    Personally, I would love to see this program as a deal to eliminate the mortgage-interest deduction. That is a much bigger distortion of the housing market than this would be.

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