Stocks Rally On Housing Bailout Rumors
Kurt Brouwer April 1st, 2008
There have been several positives that have surfaced today. For example, Lehman Brothers announced a big increase in its capital thus easing concerns that it would be another Bear Stearns. Also, there were pretty good tidings on the economic front.
However, I think the big item may be the rumor that a Federal bailout of troubled home mortgages is on the way:
Administration Hints It May Guarantee Underwater Loans (Investor’s Business Daily, March 31, 2008, Jed Graham)
The Bush administration may be moving closer to embracing the most sweeping idea in Congress for putting a floor under housing.
Under the plan, the government would take over distressed mortgages after the current holders agree to slash the value of the loans to reflect falling home prices.
In effect, the government would swap cash for nonperforming loans, pumping liquidity into the financial system. Because the plan would lift borrowers with negative equity back above water, homeowners would have greater incentive to avoid foreclosure.
House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Chris Dodd have made such proposals. Federal Reserve Chairman Ben Bernanke backs the general idea. Now, recent comments and news reports signal that the administration is readying a similar plan.
…President Bush said in his Saturday radio address that the administration was “committed to building on” its efforts to help struggling homeowners and was “exploring ways” to do so…
At this point, we do not know what will be proposed, so there is not a lot we can say about this idea. It is clearly something that has quite a bit of support on Wall Street. For example, in his recent commentary, Bill Gross wrote this:
From Gross’s April 2008 Commentary [emphasis in the original]:
…Ultimately government programs which support private credit market assets may be required in order to prevent an asset deflation of significant proportions. Authorities must act quickly, with a shot of adrenalin straight to the heart of the problem: home prices. Since homes are the most highly levered and monetarily significant asset that American consumers own, if they decline much further they will drag the rest of the economy with them. Supporting home prices goes counter to the thinking of Republican orthodoxy. President Bush and Treasury Secretary Paulson argue that markets must “clear” in order to avoid similar mistakes made by Japanese authorities in the 1990s. Yet we may have passed the point of no return for “clearing” markets. Home price declines of 20% are in fact much more of a shock to the American economy than the popping of the Internet bubble and NASDAQ 5000, because the amount of homeowner leverage is so much greater. A 20% negative adjustment not only wipes out all ownership equity for millions of Americans, it turns their homes “upside down” - incentivizing them to let their gardens grow weeds instead of lettuce. The decline needs to be stopped quickly in order to avert additional crises.
There are lots of issues — pros and cons — on such an action. And, we have more questions than answers. Is it a bailout of people who simply made foolish decisions to buy homes they could not afford? Is it a bailout of real estate speculators or banks or Wall Street firms?
At this point, we really cannot say although early indications are that banks and other mortgage holders will still take quite a hit on these loans, so there is no obvious bailout there. It seems to be targeted at homeowners who are struggling, but want to remain in their homes.
Will it happen? In my experience, politicians love to be seen taking action to avert a crisis so there is a pretty fair chance that a bipartisan bill will be introduced soon. We’ll have more on this as it unfolds.
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Kurt, thank you for posting this article.
A bailout is a really bad idea. Taxpayers would be rewarding greedy (and sometimes dishonest) borrowers who bought something they couldn’t afford along with reckless and unscrupulous lenders. Where’s the logic in that?
The solutions being floated in the article don’t need government intervention. The lenders could reduce the size of the loans and agree to share in future appreciation with the homeowners directly if that’s the solution.
Nowhere does anyone address what happens if home values continue to drop. Yet another bailout? Imagine what impact that would have on our economy and the value of our currency.
Also, if homeowners get bailed out and have little upside, what’s to stop them from just swapping to another home of similar value and thereby reaping all the appreciation? Then the government gets left holding the bag even if values don’t drop any further. I don’t envision how they could prevent people from doing that.
The private sector created this problem and it’s certainly not the first asset bubble the world has ever seen. The others all worked themselves out over time and this one will too. Throwing the government in the middle for purely political reasons with taxpayer funding and subsequent liabilities is a huge mistake.
Very good points Penelope. I agree with you on all your points with only the merest quibble or two.
One quibble is that I believe this financial panic came about through a public - private partnership. That is, government decided that broadening home ownership was an overriding concern so it pushed lenders to offer loans to people who were marginal or poor credit risks (for example, the Community Reinvestment Act of 1996). Lenders figured out how to play ‘hot potato’ with these dicey loans and thus they forgot entirely about risk.
The other quibble is that many lenders are not offering mortgages now (or are doing so at high rates) because their capital is impaired. That makes it hard for those who want to buy to do so. If the government steps in and values mortgages at a 20% or 30% discount, then the credit system can begin functioning again because all parties will know what a given company’s assets are worth and what its balance sheet looks like.