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Foreclosure Relief

Barney Frank and friends are finishing the touches on “foreclosure relief” in the form of $350 billion in TARP funds. The favored logic of the Washington crowd is that since housing is at the heart of the crisis, it is most important to “stabilize” the housing market, and that foreclosure relief is the best means to do so. The funds will be released to the Treasury with conditions that President Obama and Secretary Paulson will agree to programs that cut interest rates and “forgive” a portion of principal on mortgages. There are two elements to this that are inherently flawed. One is the economic aspect and the other is the moral aspect.

From an economic perspective, in terms of creating stability in the housing market this plan does anything but that. I would define stability as a situation in which supply and demand meet, so that there is a fair market value established for real estate. Given that this price is set by a constant stream of transactions between buyers and sellers, as with all markets the housing market is unstable until it clears.  Just as in trying to flatten out market cycles however, the truth that stabilization is generated by chaos is lost on Washington.  

By artificially reducing interest rates and thus prolonging the time before foreclosure for those who cannot afford their houses, the market value of these houses will remain artificially high. This is because the government will reduce the supply of houses that otherwise would have been foreclosed and liquidated, thus keeping imprudent people (at least temporarily) in their homes and people with the cash to purchase the homes out.  Since house prices will remain artificially high, it will take even longer for mortgage-backed assets to reach their true market value as well.  In addition, the banks providing the mortgages will receive less money than they otherwise would have were the market for houses free, both in terms of lower interest rate payments and the government-imposed “forgiveness” on a certain percentage of mortgage principal.  To recap, the government steps in and alters a private contract so as to relieve the debtor at the expense of the creditor.  This seems like a great incentive for banks to continue to lend in the future.  

The other aspect of this is the moral one. First, what kind of precedent does the government set if when a homeowner can’t afford a home, the government can arbitrarily abrogate a contract made by two private consenting individuals in favor of one side — and the side of the debtor no less? This creates a major moral hazard, because now people will see that if they go into serious debt to buy a home, the government will bail them out by offering more favorable terms if they fail to fulfill their obligations.  Of course I suppose this precedent has already been set in people’s minds given the government’s increasing socialization of risk in the private sector.  

There is a second major moral problem with this as well. The law of the land here is favoring debtors over creditors. The conception that one should “forgive” a portion of principal on a mortgage is absolutely ludicrous. The person who saves their money does the debtor a favor by lending them money, and so the fact that just because market conditions change, the creditor than has to sacrifice his or her rights to the person who borrowed in the first place is egregious. To be sure, a saver takes a risk by lending, but they also have a contractual right to certain claims if the debtor cannot fulfill his or her obligations, so for the government to be able to intervene and “relieve” the debtor to me seems unjust.  If contracts can be violated by government fiat then the glue of society must come undone.

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