Foreclosure Myths

Barron's recently published their proposed plan to solve the housing financial crisis: "Mortgage Relief for Everyone." Here is the four step plan summarized:


I've been reading a lot of this kind of nonsense in the popular press but was a little flabbergasted such a proposal was coming from a free market publication and was compelled to reply. They actually printed the letter below:

Dear Editors:

I must respectfully disagree with all four points of your plan. First, low, subsidized financing is what turned real estate investment into a financial asset akin to an option on a bond. Low mortgage rates recapitalized housing based on the debt service required to buy overvalued housing assets on the margin. The temptation of easy financing caused buyers to view housing as a sure thing with quick turnover. But all one-sided gambles soon end and now we’re saddled with a severe balance sheet problem where incomes and rents are insufficient to service outsized mortgages.

By reducing lending rates your plan merely addresses the balance sheet insolvency problem by artificially inflating the servicing of mortgage debt. This is like a little hair-of-the-dog to cure a hangover. But in the case of an asset bubble, this can only prolong the pain because your plan merely seeks to maintain these overvalued assets, while a functioning housing market going forward needs to correct them. Equity returns on overpriced housing will continue to be negative and buyers will choose to put their funds elsewhere, if they’re at all sensitive to yield. I, for one, do not want my most important asset to have a negative return for the next 5-10 years and I certainly wouldn’t borrow money at any rate to buy such overvalued assets.

It’s necessary to return housing prices to some rational level consistent with personal incomes and implicit rents. It’s time to manage the losses, not deny them. The only other option is to inflate incomes until the real value of housing equals the depreciated nominal value of mortgage debt. But this comes at the cost of all other investment alternatives, especially savings. It would also sacrifice the credibility of the dollar – an economic risk that may be incalculable.

This kind of fuzzy thinking can only be cleared up if we burst a few myths about foreclosures. Let's say someone bought a house at $600K with 5% down plus closing costs and financed the rest with a $570K loan. After a 25% decline in housing prices that house is now worth $450K and the owner is looking at a $150K loss of which his/her equity is only $30K. Does this person want to avoid a foreclosure? I think not. If fact, they're begging to push that $120K loss off on somebody else - i.e., the banks and investors who underwrote the mortgage-backed securities - and walk away.

These investors and lenders in turn would also like to push the loss off on somebody else - say, back to the original owner or the taxpayer. This argument about saving peoples' houses is really an argument on how to stick them with a really bad housing investment for the life of their mortgage. This may sound like just deserts, but how are these buyers, many of whom came from the lowest income brackets, going to save for the future when an overpriced house sucks all their disposable income down a black hole? They are going to be even more dependent on government benefits in the future. This was not the way to promote "an ownership society." The political rhetoric about "helping poor folks stay in their houses" is no benevolent altruism. The better route would be to let people foreclose and then manage the losses across the financing chain. The sooner housing falls to a realistic level, the better off our economy going forward will be. And inflation is definitely the stupidest route out of this cul-de-sac.

In the next housing phase, where most homes will be looking like a capital loss rather than a gain, we need to return prices to an economically rational level ASAP. Housing is paid for out of incomes and rents. There is a reasonable multiple of income, usually roughly 4x to borrow against for residential home purchases. There is also a reasonable multiple of gross rents that imply a fair housing value. Living in a world where there is no rational connection between these fundamental cash flow values and the price of the underlying real estate means we will be living with a dysfunctional market for a long time to come. There's only one thing worse in real estate than owning a house you don't want - having it own you.

Why Blue Needs Red (and Vice-Versa)

Pundits and casual observers have come up with all sorts of ‘theories’ to explain the red-blue divide in our politics. But the voting evidence tells a different story than the exit polls and media narratives. There are many cross-cutting divisions in our politics, but the red-blue divide is best explained by three coinciding factors: lifestyle, party and ideology. Since the 1960s the lifestyle differences between urban and rural have become aligned with liberal and conservative ideologies. This alignment has then been amplified by partisan electoral strategies and governing platforms that target these divisions. The result is that rural communities have become more conservative and Republican while urban communities have become more liberal and Democrat. Suburbs are now the tipping point, or battleground, if you prefer. Both election campaigns were well aware of this and Obama had considerably more resources to campaign in the suburbs nation-wide than did McCain. Money and the economic crisis is what delivered the election to Senator Obama.

So, will it be a battle that’s always going to be fought to a win-lose rather than win-win result? Last time country rubes, next time city slickers? The majority of the voters voiced their displeasure with this distraction and both candidates did their best to campaign on their bipartisan credentials.

But here’s the rub. The split between rural and urban values differs across many political issues and policies. These differences are eminently legitimate and beneficial to our national identity. However, our mainstream media and most of our commercial culture is heavily biased in one direction. These media industries are based in urban America and tend to reflect urban values. This is not necessarily malicious, but the reason we have few conservative reporters, TV news analysts or Hollywood script writers is because these professionals have predominantly come to reflect their urban liberal preferences.

“So,” liberals might ask, “what’s the problem?” The problem is that broad swaths of the country are founded on more traditional, conservative values. These Americans may enjoy entertainment fare from the city, but they have no desire to embrace the same values and lifestyles. Many of these traditional values are also shared by urban and suburban dwellers, but the small towns of America provide the roots from which American culture spreads its many diverse branches. Rural areas also offer a respite from the rat race, the impersonal and stress of urban living. They provide the necessary link to nature, our neighbors, and the land.

I would argue these traditional values provide an important touchstone for our national culture that promotes the diversity and colorful experimentation that goes on in the more fluid, progressive, urban environment. Americans are not really black-and-white conservative or liberal – they are tolerant and traditional. Our liberal ideology emphasizes the tolerant while our conservative ideology emphasizes the traditional. If either of these were to be snuffed out I'm sure we would be poorer in soul and spirit for it.