The Senate worked speedily last week to cook up a bipartisan rescue package for the nations housing market. But as that market continues to correct and the economy churns, its likely that the Foreclosure Prevention Act of 2008 is only the start. This $15 to $20 billion package may be just a down payment on what could become, by Election Day, a housing bill costing hundreds of billions of dollars. The current bill, though relatively small, is a prelude to what a big bailout would look like: it calls for homeowners and taxpayers who dont need rescuing to sacrifice their individual private wealth for a collective public benefit. And it wont even achieve that misguided goal.
Democrats and Republicans have agreed on the package because it contains something each side wants: for the Left, cash for nonprofit aid groups; for the Right, false gestures toward conservative principles. If the House passes the bill and President Bush, who seems receptive, signs it, the Democrats will deliver $100 million to nonprofits to offer foreclosure-prevention counseling, as well as $4 billion in block grants to local and state governments to buy foreclosed properties. For the Republicans, the deal contains what many members will pretend is a free-market approach to the crisis: tax breaks. First, anyone who buys a foreclosed home, or a home approaching foreclosure, in the next two years will get a $7,000 tax credit. Second, homebuilders, banks, and other firms taking a big financial hit in the current crunch will be able to apply this years losses to taxes they paid in past years, receiving retroactive tax benefits at a cost to taxpayers of about $6 billion. Theres also a feature that has won support from both parties, as well as from President Bush and Treasury Secretary Hank Paulson: the bill grants local and state governments the ability to raise $10 billion in tax-exempt bonds to refinance distressed mortgages in their communities.
Problems abound with each part of the bill. The $100 million of foreclosure-prevention counseling is preordained to be ineffectual without an even larger taxpayer bailout: if you cant afford your mortgage, counseling wont help. The $4 billion in block grants will allow city and state managers to buy properties from grateful banks at still-inflated prices and plunge into the property-ownership and landlord businessa business at which government has never excelled. The retroactive tax breaks for homebuilders and banks are blatant favoritism: why do these institutions deserve to be shielded, at taxpayer expense, from the full brunt of their scarcely believable business misjudgments over the past half-decade? And the plan for governments to borrow money with which to issue new, more affordable mortgages to struggling homeowners exposes taxpayers to a huge new risk. If homeowners default on these new government-guaranteed mortgages, local governments will be the ones paying the bill, at a time when, because of a drop in property-related tax revenues, they can least afford any new spending.
Compared with the other proposals, the $7,000 tax credit for buyers of foreclosed properties seems innocuous at first. But its actually a perfect example of how the government is willing to sacrifice private benefit in a futile quest to thwart the markets and achieve social gain. Its easy to understand Congresss motivation: federal, state, and local leaders dont want to see houses sitting vacant and deteriorating, encouraging squatting and other crime in beleaguered neighborhoods. Congress wants to achieve a public benefit by encouraging private investors to buy up tens of thousands of these foreclosed homes, halting neighborhood decay and thus benefiting all homeowners and citizens.
But it wont work. Between last year and this year, according to the National Association of Realtors, the median price of existing homes fell from $213,500 to $195,900. That $17,600 drop is more than double the proposed $7,000 tax credit, and a bottom isnt yet in sight. Potential investors think that prices have further to fall, particularly in overbuilt regions where prices more than doubled between 2000 and 2006. A $7,000 transfer from taxpayers to buyers of foreclosed homes wont magically halt this necessary slide.
What it will do, however, is ensure that homeowners not in foreclosure are penalized if they try to sellsince the few potential buyers taking a chance in the current climate will insist that sellers cut their prices to compete with the tax credit for that foreclosed house down the street. And it means that when the market finally does find a bottomif it does so before the tax credit expiresthat floor price will be higher than it would otherwise have been, because buyers setting the price on foreclosed homes will have that extra government subsidy with which to bid.
Key members of Congress have located another flaw in the bill: it isnt ambitious enough. Under a plan proposed by Representative Barney Frank, the feds would guarantee up to $300 billion in distressed mortgages in return for the banks taking some losses on those mortgages by cutting the amount owed. Senator Chris Dodds plan would allow judges to modify the mortgages of homeowners who declare bankruptcy, either by reducing the amount owed or by changing the interest terms. Either plan would wantonly sacrifice private benefit in an attempt to achieve social gain. The first would put all taxpayers on the hook for future mortgage defaults. The second would mean higher interest rates on mortgages in the future, because mortgage investors would demand higher payments to protect them against the risk that bankruptcy judges could change the terms of future loans, cutting their expected profits.
When some version of the current bailout package comes his way, President Bush should veto it. Otherwise, hell probably find himself explaining, in the last months of his term, why an even bigger bailout isnt even better.
Nicole Gelinas is a contributing editor to City Journal and a Chartered Financial Analyst.