Saturday, 4 July 2009

Always Taking the Path of Least Resistance

That could be the motto of Washington for its interventions into the financial markets. If you can either (a) Solve a crisis by directly confronting insolvent banks and taking measures that will cause some short-term pain but ensure a better future or (b) Roll the currency printing presses all night and flood the system with money and hope that that eventually works, over say five years or a decade or whatever ...

What do you do? (b) of course. (b) doesn't rile up the banking lobby, get any Congressional noses out of joint, threaten to anger any populist groups. (b) isn't leadership either, but leadership is a quaint notion these days. Let's face it: it's not that America is pain-averse. It's worse: we're discomfort-averse.

So, continuing our multiple choice test, if you can either try to resolve the housing foreclosure problem by either (a) Knuckling down on the banks and persuading them (through legislation, if need be) to renegotiate mortgages so that both the homeowner and the bank take a hit, but at least the homeowner has an incentive to start paying the bill again or (b) Flood the system with cheap money and hope the problem goes away ...

What do you do? (b) of course. It's the path of least resistance.

But now comes evidence that this approach, while convenient and non-controversial, unfortunately has a little drawback: it doesn't work. Check out this commentary by economics professor Stan Liebowitz in the WSJ:
What is really behind the mushrooming rate of mortgage foreclosures since 2007? The evidence from a huge national database containing millions of individual loans strongly suggests that the single most important factor is whether the homeowner has negative equity in a house -- that is, the balance of the mortgage is greater than the value of the house. This means that most government policies being discussed to remedy woes in the housing market are misdirected.

More specifically:
The Obama administration's "Making Homes Affordable" plan focuses on having the government help lower obligation ratios (the share of income devoted to house payments) down to 31% from levels somewhat above 38%. But my analysis finds that mortgages having such obligation ratios at closing did not later experience high foreclosure rates. This suggests that reducing these ratios is not likely to significantly improve the foreclosure problem.

So here's what this means, and it's very common sensical: Your biggest asset is a house. You're paying on it for another 10, 20 years. If you owe say $200,000 on it, but it's worth $250,000, you'll want to keep paying off your mortgage. But if you owe $250,000 and it's worth $200,000, you're more likely to say, "Bleh. I'm staring at a $50,000 loss. Sayonara house."

It's abundantly obvious what should be done. Washington needs to find a way to facilitate the renegotiation of mortgages for homeowners who are underwater. Or, of course, it can take the path of least resistance: throw a few trillion at the problem and hope it goes away.

*Sigh*