“ As president of the United States, Alan, I would order the secretary of the treasury to immediately buy up the bad home loan mortgages in America and renegotiate at the new value of those homes — at the diminished value of those homes and let people be able to make those — be able to make those payments and stay in their homes… Is it expensive? Yes. But we all know, my friends, until we stabilize home values in America, we’re never going to start turning around and creating jobs and fixing our economy.”—Senator John McCain (R-AZ) at the second presidential debate.
At Tuesday’s presidential debate, Senator John McCain (R-AZ) unveiled his controversial proposal to “stabilize” home values by allowing borrowers who cannot afford their mortgage payments to renegotiate with the govenrment at the diminished value of their homes. His idea is that the new mortgages would have the principal balance due reduced to reflect the lower home value.
There are two critical problems with this proposal: 1) it will not stabilize the fall in home values; and 2) it will make the inevitable market correction longer and deeper than it would have been.
First, it is based on a false premise: that foreclosures are the driving force in falling home values. That plays a part, but generally speaking, the catalyst was dramatic oversupply, per se—along with the government forcing banks to make bad loans and driving interest rates below what the free market warranted. The rash of foreclosures is largely the result adjustable rate mortgages, equity loans, etc. In other words, they are happening because of the decisions made by borrowers to borrow on bad terms and lenders to oblige them at the government’s behest.
What Mr. McCain is proposing is essentially a federal mortgage modification program. Here’s the gag: banks are already modifying mortgages. They’re not particularly well-advertised, but they are available. In other words, Mr. McCain’s $300 billion proposal is actually unnecessary. To make matters worse, the $800+ billion bailout that has already passed Congress essentially gives the Treasury Secretary the power to basically do what Mr. McCain suggests. And, to make matters worse, it is actually interdicting the private sector’s modification momentum.
For individual borrowers who are having trouble making payments and/or whose value of their home has decreased below the value of the actual mortgage, they should approach their lender and let them know what the situation is. It’s not guaranteed that the lender will oblige a modification request. But the fact is that it’s in the bank’s interest to renegotiate rather than foreclose because it will receive more from the former.
By inserting government into the mortgage modification business, what will really happen—other than wasting another $300 billion—is that the amount of loans guaranteed by the federal government will increase. Mr. McCain is proposing to renegotiate loans whether or not they originated from the federal government. For the loans that are already backed by the federal government, they would be adjusting the terms. For those that are privately held, the government would be purchasing the mortgages and changing the terms.
End result? Rather than engage in modifications, private banks would just end up dumping all of their bad paper on the government. This creates a false economy and postpones actual price discovery from occurring. This prolongs the market contraction because the government inserts itself to prop up property values on a massive scale, and the government winds up owning even more homes.
Left to the market’s own devices, the correction will come of its own accord. The more government gets involved, the more distorted that correction will be. The solution is to allow the correction in home values to occur. The market is already working itself out. Mr. McCain’s plan is unnecessary, redundant—and, frankly, destructive.
