How Helping 'Homeowners' Makes Things Worse

Obama announced a new plan to help renters (oops, 'homeowners') who cannot afford their mortgages.

There are two types of people who aren't paying their mortgage bills, and it is not simple to separate them. There are those whose incomes are insufficient to make the monthly payment. Then there are current homeowners who are merely underwater, and do not want to pay (mortgages are limited liability, so they can walk away and not owe anything). So the government has some rule, and 30% of people with such mortgages get to basically write down their old mortgages to a new level that make them able and/or willing to pay. There are two problems with this.

First, it directly lowers the value of the bank's assets. We are simultaneously trying to shore up banks. That the government is legislating this implies that banks will have to write down their assets more than they would have otherwise. So, it is directly inconsistent with the Treasury's other objective, to strengthen banks.

Secondly, it generates huge moral hazard. Say 4 million mortgage owners take advantage of this as targeted. Those who where not targeted, will look at what their neighbor did, on a house bought at the same time, and try to figure out how they too can write down their mortgage obligation. A good number will successfully navigate the lame top-down criteria applied, because any cookie-cutter criteria in Washington creates a very simple target to game. This process will put more pressure on housing, because it creates zombie properties as owners figure out if they can get this done, and it creates a new wave of defaults. Thus, previously people who, while underwater on the property or in trouble because of standard vagaries of chance, might have otherwise paid their mortgage. But to do so in this environment is to be a sucker. Many will find this unethical, but many won't. This creates the second wave of mortgage defaults, the opportunists. I imagine there will be incentives on the demand and supply side to play this game.

The most melancholy of human reflections, perhaps, is that on the whole, it is a question whether the benevolence of mankind does more good or harm.

Walter Bagehot