Tuesday, July 31, 2012

Outrageous Housing

As mentioned earlier, this blog is a chance for me to vent. And something happened JUST NOW that deserves your attention.

Our good friend, Ed J. DeMarco, who heads the Federal Housing Finance Agency, just announced that he will object to the Obama administration's efforts to reduce the principals that homeowners owe on their mortgages. So many houses in foreclosure has led to a severely depressed housing market,  declining housing prices, more and more people just packing up and mailing their keys back to the bank, creating more people who are underwater on their mortgages...basically a vicious financial and business cycle.

The best way to stop this deflationary cycle is to offer debt relief. For a small price to taxpayers (in the short-run), the principal is re-negotiated at current interest rates. People then get to stay in their homes, Fannie and Freddie don't take a total loss on the home because people are still making payments on their mortgages, and the money that people are sending to banks (who are refusing to lend and just sitting on their deposits anyway) could be spent on on other goods and services, stimulating demand and economic growth (and increase tax revenues), and housing prices start climbing again as fewer homes go into foreclosure! It's basically a giant tax break or reduction. Win, win, win, win! Both Republicans and Democrats have favored this sensible, or SOBER, (see that word again!) plan.

DeMarco rejected this idea. In a letter to the Obama administration, he stated that the costs outweighed the benefits. He basically believes taxpayers--not homeowners, the agencies he runs, nor the overall economy--would benefit enough. Yes, taxpayers would have to pay for this activity, and the uncertain benefits are outweigh by the even more uncertain risk of moral hazard. This ignores the fact that everyone is made better off in the medium to long-term, if we have a tiny amount of loan forgiveness now. [And I won't even get into how beneficial it would be to forgive student loan debt!]

Economists and other experts have resoundingly objected to DeMarco's objections. Some say he doesn't have the power to decide these matters. That he was charged with managing Freddie and Fannie and should not be concerned with matters related to the federal budget and taxpayers. I'll let the lawyers work that one out, however.

What irks me the most here is that he has an incorrect notion of what moral hazard is--or is at least applying it to this case incorrectly. What is moral hazard? In a nutshell, it occurs when a person is incentivized to engage in behavior that was previously detrimental to his interests because he is now insured against the consequences. It pays to fail (somewhat). For example, moral hazard occurs when people buy any type of insurance. A person is rational to purchase insurance because in today's modern world you can't possibly prepare for all of the possible events or actions of others (or, yes, your own) that can severely affect your financial position. Rationally, you don't have the time or money to worry about every possible disaster and save money for every possible negative event that comes your way, such as cancer, a car crash, accidental housefire, or you hit someone on the golf course in the head with a golf ball with an errant drive and you get sued. It's also rational because it makes more sense allocating your scarce resources to activities that will have bigger payoffs, instead of the rare chance of something bad happening. It's only irrational, i.e., a waste of money, in a sense, if you know AHEAD OF TIME that you will always have perfect health, never get into a car accident, have a fire or storm damage, or have someone fall on the ice in front of your house. NEVER HAPPENS! [Not that I don't think my insurance payments are waste of money sometimes, until I get into that major accident that my co-pilots think is just around the corner...not literally!]

So, you buy insurance to cover you in case of those low-probability, high-impact outcomes. And insurance companies make a LOT of money doing it. That's the point. BUT, by insuring you, you are SLIGHTLY more likely to engage in risky activity, because you are now partly protected in case of failure, controlling for other factors. So, when people buy hurricane insurance, they are more likely to build a house on a beach in Florida---"After all," they say, "I'm insured!" If everyone did this, then everyone would have the incentive to "fail" and the whole market come tumbling down, and the market would cease to exist or not even come about in the first place, even though it could operate just fine with a bit of monitoring. That's what's known as market failure (not the failure of markets).

Well, the answer is not to eliminate the entire insurance industry! Instead, insurance companies MONITOR you! They pay a lot of money to make sure that you won't do the behavior that you're insuring against. Of course, adverse selection is also a problem. Those who are most likely to need insurance, can't get it. This applies to smokers (for health insurance), people who live on faultlines (home owner's insurance), and teenage drivers (car insurance). That's one way to reduce the effects of moral hazard; only select the best candidates for insurance (or make those who are riskiest pay a LOT more).

So, what does this have to do with DeMarco? Well, he basically believes that if we work to forgive a small amount of homeowners' principals, who have mortgages from Fannie or Freddie, OTHERS will be incentivized to go underwater as well. He writes:

"The sheer size and public awareness associated with the Enterprises [Fannie and Freddie], including the need for a consistent set of public rules regarding implementation, greatly enhances the likelihood of altering borrower incentives by implementing HAMP PRA [Obama's plan]. Even within HAMP PRA as undertaken by other lenders, the subjective, internal decision-making of those lenders creates an opaque environment that inhibits a general rule that borrowers might use to engage in strategic efforts to attain principal forgiveness." What nonsense!

In plain English, he thinks that if we forgive current homeowners, others will have a incentive to go underwater too, i.e., not make their mortgage payments on time, because of some subjective change in attitudes in an opaque environment! Got news for you, DeMarco, that ship has sailed! We ALREADY have thousands of people who are underwater, even though they were NOT incentivized to be so. So, we can't say moral hazard CAUSED the mortgage crisis. Unemployment, stagnant wages, and falling home prices all better account for why people need to be "bailed out."

And this hypothesis leads to an absurdity. How many homeowners say to themselves, "I'm making my mortgage payments on time, but I'll default and go through refinancing, ruin my credit, all just to shave a little off my principal?!?!" NONE! Or very few. And if you really think that the number of borrowers who default on their mortgages is going to increase so much that no bank will want to lend any longer because the borrowers can always refinance, and interest rates will, thus, go up, because banks will think everyone is riskier, then just put some limits on the program. Put some restrictions on the renegotiated principal. Limit it to people with a certain income, time period, or degree to which someone is underwater. But that ship has already sailed. And monitor people. Make sure they're making their payments on time.

My point here is that most people who are complaining about moral hazard are ignoring the fact that the disaster that should have been avoided already happened! It's like saying, "Oh, no, we won't insure you against tornadoes, even though a tornado just hit your house and now you need help rebuilding your house, BECAUSE we're afraid that OTHER people will build houses that get hit by tornadoes." And you're blaming the disaster on moral hazard, when it had nothing to do with it. In the meantime, an entire community is destroyed, people are injured, and it would be cheaper to just rebuild the town and everyone benefits from the town being made better off.

Of course, there are two objections here.

1. The system is currently rigged to allow people to do this. That the system encouraged moral hazard. Well, that DEFINITELY applies to the banking crisis of 2008, but I don't have time to get into it. But, if you think a homeowner is MORE LIKELY to go into default with his mortgage just because he has mortgage insurance now, you're insane...or just don't know what the total ramifications are for a homeowner if they default on their mortgage.

2. Libertarians will oppose this plan. "Everyone is on his or her own!" they say. They argue that if you default for no fault of your own (which is not the problem of moral hazard), then you're SOL. Well, there are ways to argue against that on moral and political grounds. But, for now, there's the economic one. We're all better off economically, including the libertarian, if we do so, EVEN IF it was their fault, which it wasn't.

Fire DeMarco!

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