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Housing Finance: For Once, Please Leave It Alone

Wednesday, July 6, 2011

The housing sector is not well. Politicians to the rescue?

The housing sector of our economy continues to struggle by virtually any metric. The Standard & Poor’s/Case-Shiller home price index is down 4 percent from where it was in April 2010, and 33 percent from its peak. New housing starts in May were 3.4 percent below the May 2010 rate. And 23.1 percent of homeowners are “underwater”—they owe more to the bank than the value of their home, an estimated $750 billion more than their homes are worth.

When confronted with a problem such as the one currently playing out in the housing market, policy makers are by nature oriented toward identifying and implementing a solution. In this case, if politicians could craft a solution that would save the millions of affected homeowners and help right the economy, they could claim a political victory heading into an important election, while homeowners, builders, and lenders would all be relieved of a massive financial burden.

If only such a solution existed.

Given the distortionary effects principal write-downs have on homeowners’ incentives, this is a clear instance in which policy makers should resist the urge to ‘fix’ the problem.

Many people have suggested principal write-downs for underwater borrowers—that is, when a bank reduces the principal amount owed on a mortgage—as the ideal answer for borrowers and lenders alike. The logic is that such write-downs can save the homeowner from defaulting on the loan and can save the lender the losses associated with foreclosing on a home, which are estimated to be greater than the loss from reducing the principal.

Economists recently pointed out that mandating that the banks provide this option to borrowers gives people who would not otherwise default on their loans the incentive to lead the bank to believe they will, in order to get the same break they see being handed to their neighbor.

While the concept of government-mandated principal write-downs has been popular in some circles for the last several years, it is garnering more attention recently because of the role write-downs have played in ongoing settlement negotiations between five banks and the 50 state attorneys general investigating the banks’ foreclosure procedures. In March, the attorneys general proposed settlement terms that would have required banks to fund principal write-downs. Prompted by dissension among the attorneys general over this policy, the latest development in the negotiations is that individual states may be able to direct the use of settlement funds. Moving away from requiring principal reductions is a step in the right direction, but the concern remains that some states will still choose that route, beguiled by the idea that principal write-downs are the answer to homeowners’ mortgage woes.

Mandating banks to reduce mortgage principals gives people who would not otherwise default on their loans the incentive to lead the bank to believe they will.

Given the distortionary effects principal write-downs have on homeowners’ incentives, this is a clear instance in which policy makers should resist the urge to “fix” the problem. They will almost certainly do more damage than good by insisting on principal reductions.

Government intervention should be reserved for market failures, and this is not one. The best course of action at this point is to let the market work. If it is in the banks’ interest to reduce principal for underwater homeowners, the banks will most certainly act in their own interest. Because a policy mandating write-downs cannot be precisely limited to influence only the people who might actually need it, intervention in this case could allow homeowners who do not need assistance to take advantage of the funds.

Alex Brill is a research fellow at the American Enterprise Institute.

FURTHER READING: Brill has also written “Please Actually Read My Research” and “The Unemployment Insurance Crisis.” More recently, he has given several testimonies including “Social Security's Finances,” “The State of U.S. Manufacturing,” and “Retirement Security: Challenges Confronting Pension Plan Sponsors, Workers, and Retirees.” Related articles include Peter J. Wallison’s “When Economic Policy Became Social Policy” and Alex J. Pollock’s “Living in the Political Wake of the Bubble.”

Image by Darren Wamboldt/Bergman Group.

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