How Not to Save Housing

WASHINGTON -- In politics, it is imperative to be seen as "doing good." The present housing crisis is a case in point, as Congress now seems increasingly intent on aiding millions of homeowners who can't easily pay their mortgages and may face foreclosure. This sort of rescue looks good, even though it is a bad idea and might perversely delay the housing recovery.

No reasonable person takes pleasure from seeing people lose their homes, and Congress is understandably upset. Estimates of defaults in 2008 run up to 2 million. If realized, that would be roughly twice the 2006 level and about 2.7 percent of the nation's 75 million owner-occupied homes. It would be the highest rate since World War II but well below much higher rates during the Great Depression, says economist Kenneth Snowden of the University of North Carolina at Greensboro.

The best-known congressional proposal comes from Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee. (The Bush administration is reportedly considering a similar plan.) It would authorize the Federal Housing Administration (FHA) to guarantee $300 billion of new home loans to strapped homeowners, allowing them to refinance their existing mortgages at lower rates and lower outstanding amounts. Under it, homeowners who borrowed from Jan. 1, 2005, to July 1, 2007, would be eligible for new loans if their monthly payments of interest and principal exceeded 40 percent of their income, well above a more prudent level of 30 percent.

Existing lenders would have to take a sizable write-down to qualify for having their loans repaid by the government. The FHA would pay the existing lender no more than 85 percent of the property's present appraised value; the FHA would then charge the homeowner for a loan at 90 percent of the appraised value. The extra 5 percent is a cushion against losses. (Example: A $200,000 home with a 100 percent mortgage has already declined 10 percent to $180,000. The FHA loan repays the existing lender 85 percent of that, about $153,000. The existing homeowner's new loan is at 90 percent of that, or $162,000.)

Everyone wins from this arrangement, say its supporters. Homeowners -- some victims of deceptive lending practices -- stay in their houses. Neighborhoods don't suffer the potential blight of numerous foreclosures. Housing prices don't go into a free fall, depressed by an avalanche of foreclosures. Although lenders take a loss, the losses are lower than they would be if homes went into foreclosure. That's a costly and lengthy process that could involve losses of 50 percent or more.

The Frank proposal and others like it put politicians on the barricades, trying to protect needy homeowners. The imagery is flattering. But there are two glaring problems: one moral, the other economic.

About 50 million homeowners have mortgages. Who wouldn't like the government to cut their monthly payments by 20 percent or 30 percent? But Frank's plan reserves that privilege for an estimated 1 million to 2 million homeowners who are the weakest and most careless borrowers. With the FHA now authorized to lend up to $729,750 in high-cost areas, some beneficiaries could be fairly wealthy. By contrast, people who made larger down payments or kept their monthly payments at manageable levels would be made relatively worse off. Government punishes prudence and rewards irresponsibility. Inevitably, there would be resentment and pressures to extend relief to other "needy" homeowners.

The justification is to prevent an uncontrolled collapse of home prices that would inflict more losses on lenders -- aggravating the "credit crunch" -- and postpone a revival in home buying and building. This gets the economics backwards. From 2000 to 2006, home prices rose by 50 percent or more by various measures. Housing affordability deteriorated, with home buying sustained only by a parallel deterioration of lending standards. With credit standards now tightened, home prices should fall to bring buyers back into the market and to reassure lenders that they're not lending on inflated properties.

If rescuing distressed homeowners delays this process, the aid and comfort that government gives some individuals will be offset by the adverse effects on would-be homebuyers and overall housing construction. Of course, there are other ways for the economy to come to terms with today's high housing prices: a general inflation, which would lift nominal (but not "real") incomes; or mass subsidies for home buying. Neither is desirable.

None of this means that lenders and borrowers shouldn't voluntarily agree to loan modifications that serve the interests of both. Foreclosure is a bad place for most creditors or debtors. Although the process is messy, promising to lubricate it with massive federal assistance may retard it as both wait to see if they can get a better deal from Washington, which would then assume the risk for future losses.