Thursday, December 04, 2008

The Bloody Mary Approach

The Treasury Department has realized that the best cure for a hangover is...more binge drinking!

I was going to write a snarky blog post arguing about how that the government should bail me out instead of GM or CitiGroup.  But why am I against this plan?

If Treasury buys mortgages with the goal of bringing down rates, they are essentially subsidizing the price of housing.  Given that low interest rates inducing an overheated housing market is exactly what induced this mess, it seems like a step backward.

You can't undo the past.  We all collectively made a bunch of bad decisions about our homes based on temporarily distorted pricing information.  (This podcast has a pretty good explanation of what the implication for money is on our buying binge.)  Life can return to normal only once home prices make sense.

During the boom, plenty of homes we didn't need were built, because prices were artificially high.  If we prop up interest rates, two things happen, neither of which are good:
  1. We subsidize overproduction.  That's wasted economic activity.
  2. We pay the opportunity cost.  Buying down mortgage rates has no upside for the larger economy or tax payers.  At least with Citi we get a dividend.
The truth is that I'm being over-dramatic.  Housing prices are probably going to go below their eventual clearing level, since buyers are irrationally petrified of buying before the bottom and risk premiums on everything are through the roof.  

My issue here is the same as TARP - how do you set the level of arbitrary government intervention when there isn't shared success.  When we were going to buy toxic waste, the risk was that we overpay or underpay - only one of the banks or tax payers could win.  Here we have the same problem - based on the interest rates we pick, one of home buyers or tax payers will win.

There is one proposal I have seen that at least hopes to address the fundamental problem with the housing market: "property appreciation rights" (PARs).  Basically the idea is to allow home borrowers to sell their upside housing market risk to lenders.

Whoa.  That's a huge change in how houses are priced, and one that we should not take lightly. It has the potential to destroy the middle class and the American dream.

But housing has changed since 1978 - houses now price like stocks - they fluctuate.  It isn't appropriate for individual Americans to own that kind of risk exposure.  If I called my bank and said "I would like to borrow $400,000 so I can speculate in the stock market -- in fact, I am going to buy just one stock, I'll put in $20,000 of my money, and you can have a lean on the stock as collateral", well, I don't think my bank would say yes.  But if I say the exact same thing with a house rather than stock, I'm off to the races, and now I am leveraged 20:1 into a completely non-diversified real-estate position.

PARs would break the asymmetric risk we face today, where home owners get the upside of the housing market and lenders get the downside.  When the market eventually corrects, what we'll see is a tightening of credit as the market adjusts to the fact that home prices can fall.  (With a stock, you can margin about 50%.  Can you imagine having to put 50% down on your home?)  In some ways this whole mess was created by incorrect risk premiums - high leverage positions on homes based on the assumptions that the old rules apply...rules from before MBSs and CDOs and Reagen-era (leveraged) finance.

Under the PAR scheme someone (Government, business, whomever) can go in and refinance a pile of houses at cheap rates.  The up-side for the entity providing the money is the rights on future appreciation, which is the incentive for the borrower to "get of the respirator" and switch to traditional financing as soon as it's possible.  Without this, we have heads-I-win, tails-you-lose, which didn't work out very well last time around.

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