Last week, a commenter on CNBC launched into an impromptu rant against the plan to 'bail out' people who cannot afford to make their mortgage payments. You can read the transcript or watch the video if you have not yet. His main point is that we should not use government money and/or power to help people who made bad decisions, and that the people who are paying their mortgages on time deserve help more than those who are not.
The rant quickly became an Internet phenomenon. I had heard about it and knew some of the content, but not watched it. But when a student in my class asked me about it, I decided to watch it and think about it. Much of what Santelli says is correct, but the issue is fairly complicated and there are a lot of points to consider.
One thing that a lot of people do not really understand is that foreclosures are extremely expensive. They destroy wealth. A number I saw last year is that foreclosure destroys 25% of the value of the house. In some cases, foreclosure produces a property with zero or negative value. Some of this is the basic costs of moving. Even in the best of circumstances, a real estate transaction will cost up to 6% of the property value just in realtor fees, and moving a house full of stuff costs several thousand dollars. Foreclosures magnify this. There are a lot of extra court and legal fees. The bank has to start the foreclosure process, work with the court system and sheriff to serve an eviction, etc. Another part of the cost comes from vandalism and looting. When people are being kicked out of their house amid a personal bankruptcy and financial ruin, they have no incentive to keep the place in good repair. And if they can make some quick cash by selling off things like the air conditioner, the copper pipes, or the fixtures, why not? Then, if the house sits unoccupied for any length of time, you get squatters, vandals, teenagers throwing parties, etc, and you can easily end up with a ruined husk where a home used to be.
Given that a foreclosure can easily result in the homeowner suffering, the bank getting nothing, and the value of all the surrounding property dropping, it would clearly be in everybody's best interest to negotiate some kind of deal to avoid this. If the bank writes down the loan value by 10% and the homeowner pays off the loan, the bank has gained 15% of the value of the house, relative to the value if it foreclosed on the property. Sometimes the bank doesn't have to do that. If people missed two or three payments before getting their finances in order, the bank can add the missed payments to the mortgage rather than declaring it delinquent. It doesn't lose anything.
One big obstacle to deal-making is that mortgage loans are no longer owned by a single bank. They have been split up and bundled together. Instead of one lender who can negotiate, you have dozens of people with claims on the mortgage payments. In the absence of negotiation, they simply follow the letter of the law. This means that there is a thoughtless, automatic process that kicks people out when they fail to make the payments.
The government program is trying to deal with this. I don't know all the details, but from what I have heard it is a fairly good way to deal with a clear and obvious problem. If it works, then it will prevent a lot of individual pain, and might also help prevent the overall economic problems from getting worse.
However, even though the plan is good in the short run, it could have a lot of bad effects in the long run. A full understanding these bad effects requires some knowledge of economics, game theory, and incentives, but I'll do my best to give the simple version.
There are certain actions that will increase everybody's wealth, but that will only work if people can make a credible promise about future actions. You will only cooperate with someone if you have know that they will not cheat on you on the future. If you lose faith in their promise, you stop cooperating and everybody is worse off.
Mortgage contracts are like this. Banks only lent money because they believed that they would be paid back. Banks will only lend money in the future if they believe they will be paid back. If we change the rules of the game so that people are allowed to stop paying when a crisis hits, then banks will start to charge much higher interest rates to compensate for the potential loss. This will impose large costs on all homeowners in the future. Even though no money is explicitly changing hands, the government program could end up costing honest homeowners in the present and future in order to help a smaller group of delinquent homeowners today.
But the effects are worse than that. If people know that laws will be changed to suit the needs of the moment, it generates a lot of uncertainty. This kind if uncertainty makes it much harder to invest and plan for the future, and the result is that we all end up a little poorer. It is also the case that people will be less likely to be honest if they feel that honesty is not rewarded. This is the 'moral hazard' point that Santelli and others are making. If you know that people in trouble will get a bailout in bad times, you are less likely to make the sacrifices needed to keep yourself secure.
Basically, we face a choice between the large and obvious costs of foreclosures today, and the subtle costs of higher interest rates, more risk, and less investment for years in the future. It may be the case that enforcing the letter of the law and causing millions of foreclosures is the best thing to do for the country in the long run. But I am not convinced of this. Especially when you consider the costs and benefits of other kinds of intervention to help deal with the economic crisis, the mortgage bailout may be a good idea. Even though I understand the costs it imposes more than most, I feel that it may be worth paying these costs. They will be paid in the future, when things will be better, in order to prevent massive costs today, when the economy needs the help.