Everything Finance

Paola Sapienza

The Bush administration is working on a plan to help homeowners at risk of default.

This would be the second time this year that legislators intervene to help homeowners; in July, President Bush already signed legislation to help borrowers to refinance at more affordable rates. For an academic analysis of that legislation and the way it impacted taxpayers, homeowners, and the financial industry, see a recent paper by Mian, Sufi and Trebbi. Mian and coauthors argue that special interest campaign contributions from the financial services industry and local constituencies predict Congressional voting patterns when it comes to recent government interventions.

This work is a good example of the view (held by many economists) that political economy interventions are often made by self interested politicians who maximize the probability of being re-elected rather than society’s interest, and even vote contrary to their ideology in order to maximize re-election.

This paper is bad news for the next set of interventions the government is planning to undertake. Nonetheless, despite the usual reluctance many economists have toward government interventions, this time a substantial fraction of them have urged an intervention to limit foreclosures. Why are so many economists recommending these measures?

Needless to say, any bailout has distortionary effects, but I will argue that a measure that deals directly with foreclosures could at least try to address one inefficient consequence of foreclosure in the midst of this particular financial crisis. Estimates suggest that less than 50% of the value of the house is recovered by the bank when a house enters foreclosure. Thus, massive foreclosures will have very negative effects on banks’ balance sheets.

In my previous entry I argued that the quality of the assets of the banks is crucially important to determine whether the money invested by the Government in US banks was well spent and, especially, whether it will help to ease the credit crunch. As real estate prices deteriorate and homeowners face more foreclosures, the value of those assets will deteriorate further and in an uncertain manner. Since mortgages have been sold and repackaged in complicated instruments, nobody knows which banks are holding which mortgages, but everybody agrees that more foreclosures are not good news, on average, for banks.

Deterioration and uncertainty is something the economy does not really need at this time.

The advantage of a government intervention, if properly designed, is to facilitate the process of renegotiation for homeowners close to foreclosures. These proposals aim at “saving” the 50% loss that financial institutions would incur if a house goes into foreclosure. While in traditional mortgages held by a local bank, the bank has an incentive to avoid foreclosure and to cut a deal with the homeowner, in the world of mortgage backed securities, this incentive is no longer there. The mortgages have been repackaged and nobody knows who has the right/incentive to renegotiate the agreement. A government intervention should then be aimed at reducing the cost of this inefficiency and facilitate the renegotiation.

Some of the proposals add a form of subsidy to the homeowner, or the financial institutions at taxpayer’s money. According to some, a subsidy is needed to convince the parties involved to accept the renegotiation (see the New York Times for an example of reluctant participants), or simply because they believe that relief to homeowners will help the economy at large.

The latter claim is much harder to verify and it raises the doubt that the subsidy from taxpayers to homeowners and/or financial institutions is driven by self interest politicians who favor their constituencies or special interest, as the work by Mian and his coauthors suggests.

In analyzing all these proposals (and in the final proposal that the Bush administration will put forward), the important question to ask is whether the proposals minimize the cost for the taxpayer, while avoiding deteriorations in banks’ balance sheets due to foreclosures? The Economist has summarized and compared three of these proposals. It will be interesting to evaluate the final government proposal and analyze whether the proposal solves the existing inefficiencies, or rather serves specific constituencies or special interests.