As the Wall Street meltdown continues, private-sector financial institutions have no choice but to swallow the markets harsh verdict on the past decades financial engineering. Stunned global investors wont give financial firms any more money, forcing the firms into bankruptcy if theyre not lucky, or into the arms of Uncle Sam or of much bigger companies, if they are. But as the House Financial Services Committee proved on Tuesday, the public sector somehow feels it can continue to ignore realityat least for a little longer.
The committee, chaired by Massachusetts Rep. Barney Frank, took steps to gut a modest reform of the bad lending policies that helped get us into this mess. By voice vote, members moved to overturn a ban on something called seller-financed down payments for some government-guaranteed mortgages. Congress largely banned government support for such mortgages just two months ago at the request of the Federal Housing Administration.
The FHA and the Department of Housing and Urban Development have provided ample evidence that these loans are just too risky for taxpayers to take on. Under a seller-financed down payment, a homebuyer doesnt put any money down. Instead, the seller, usually a property developer, provides the homeowner with funds to prod along the sale of the house. The first problem with this approach is that it gives the homeowner little incentive to negotiate on the purchase price of a home, since it seems to him that hes getting a good dealafter all, the developer is kicking in thousands of dollars, which seems generous. The developer in turn finds it easier to charge an inflated price for the house, making it more likely that the government wont get its money back if the home ever goes into foreclosure. And in fact the homeowner is more likely to default: since the value of the home is quite likely inflated, he is more likely to have difficulty selling it for the price he paid if he runs into financial trouble. Having none of his own money at stake, he also has less incentive to struggle to make his payments.
As HUD official Margaret Burns testified last year, seller-financed down payments have had a significant negative impact on FHAs business for the last several years. Loans made to borrowers who rely on these types of seller-funded gifts perform very poorly. The foreclosure rates on these loans are more than twice those of all other home purchase loans insured by FHA. Moreover, FHA experiences higher loss rates from the sale of the properties associated with these particular foreclosures, a reflection of the overvaluation that occurs with these programs. Those loss rates could get worse; the government compiled them before the most severe period of housing declines began in many markets.
Why on earth, then, did Barney Frank & co. overturn the seller-financing ban, increasing the risk to the taxpayer? Even under the ban, home buyers could still get help with their down payments from friends, relatives, and even charity groups. And relaxing the seller-financing restrictions wont really help anyone buy a new home more cheaply than he could have otherwise, because the relaxation, by allowing some home prices to stay inflated, just delays the inevitable continued decline in the housing markets. This decline actually benefits first-time homeowners, who were previously priced out of an unaffordable market. Nor will relaxing the requirements save anyone from losing his home, because homeowners trying to sell houses wont benefit. In fact, theyll likely lose out, because developers who can offer what seem like sweet deals on new homes can now compete against sellers of older homes on unfair terms.
Yet it seems that Frank and his colleagues remain keen on coddling the tenacious bad-lending lobby (including the National Association of Homebuilders and whats left of the banking industry), which desperately needs suckers to buy newly built homes at inflated prices so that builders can pay back at least some of their construction debt to the banks and investors. Frank is certainly not looking out for average-Joe home buyers and sellers with this action. Just as bad, it seems that he and his colleagues havent noticed that the rest of the country, and indeed the world, have begun paying the price of the private sectors era of no-down-payment, 100-percent home-loan financing.
If Congress believes that it hasnt gotten its fill of taxpayer risk related to bad mortgages, it should think again. Just two weeks ago, the White House nationalized supposedly private-sector mortgage giants Fannie Mae and Freddie Mac, foisting up to $5.3 trillion in potential obligations on the taxpayers shoulders. Through Fannie and Freddie, the government already bears the risk for millions of mortgages based on hopelessly overvalued properties, mostly the legacy of the private sectors own easy-money binge.
Theres already plenty of bad debt to go around, without creating more.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.