Bailout or Handout?

Government should not screw up the real estate correction

You can tell the feds are bailing out mortgage lenders by the way no one wants to call it a bailout.

President George Bush made that clear last week when he announced his plan to rescue broke borrowers. "A federal bailout of lenders would only encourage a recurrence of the problem," Bush explained.

So this is not a bailout, you see, because it is for the borrowers, not the lenders. And if you believe that, then you'll also believe that the Federal Reserve has been shoving money at the banks by the billions in recent weeks in order to help borrowers, too.

In truth, what Bush has proposed is far worse than a bailout. Federal regulators and policies would supplant market discipline and price signals in the mortgage market. And all because a long-overdue correction in the domestic mortgage-making sector manifested itself this summer.

What is happening with real estate lending now is not unlike the dot-com bust. America survived that bubble. Then, as now, actual income-production became secondary to complicated financial constructs which obscured the underlying business. If there ever was a business. Recall that Enron invented entire energy-trading markets that ultimately dealt in nothing.

The mortgage industry is not quite that far along, but it is close. Although securitization of mortgages has overall been a great boon to both borrowers and lenders, spreading risk and allowing many more mortgages to be issued than otherwise be the case, it has also brought the derivative frenzy and the obsession with yield that has landed us in correction mode.

The very move into the subprime market—make that a stampede—was predicated on the notion that the added risk could spread thinly enough not to matter while collecting the massive bonus of substantially higher interest rate income streams. Those streams could then be further bought and sold, adding yet more margin to the endeavor.

And this worked, to some extent. Countless subprime borrowers got loans and homes and are not now facing foreclosure. This inconvenient bit of information has to be forgotten in the rush to condemn the "excesses" of subprime leading. Still, somewhere along the way, the vital link between a borrower who is making monthly payments and all the wheeling and dealing in securities was broken. Without those payments, you do not have mortgage to buy, sell, or trade. With dot-coms, it was the lack of income-producing products that triggered the correction. In past few weeks lenders—and traders downstream dealing in mortgage derived instruments—have rediscovered that is really does matter who you lend your money to, assuming you want any of it back.

There is another aspect of the current mortgage industry that is often overlooked, and it too is related to income streams. The streams are what lenders want, not the underlying real estate assets. In contrast to years past, there is no Dirk Dastardly down at the bank looking to swindle the widow out of the family farm. The banks do not want to own the assets that they themselves took as collateral for their loans—ever.

The correct federal response to this should be, "Too bad. You broke it, you bought it." Let the realtors, bankers, Wall Street sharpies, and—yes—the borrowers fight it out amongst themselves. Somewhere there is a market-clearing price for these assets.

Of course, the uber-nannies in the Bush Administration can't allow that. Instead they have opted to compound the problem by using federal assets to move in on the private mortgage insurance market and otherwise encouraging banks to forgive bad loans.

Worse, the White House intends to make the Federal Housing Administration the Federal Housing Administration by directly assuming responsibility for 80,000 underwater loans. Look for that number to double once Democrats in Congress are finished bidding it up.

In sum, we have the makings of the financial equivalent of Medicare Part D—a massive federal program in the place of a semi-private sector that more or less works. Not perfectly, but it is better than making Washington largely responsible for credit allocation in America.

The frustrating thing is that the White House and Congress are chomping to act, while the Fed's more targeted response to the credit crunch has just begun. By using the discount window to entice healthy banks to take on some of the rot, an immediate lockdown on all credit seems to have been averted. It will take time to digest the bad loans, and real estate prices might dip in some markets going forward as a result. California, for example, has a consensus 10 to 15 percent overvaluation to work through, and that may take a year or two to correct.

But that process will slam to a halt once Uncle Sucker begins assuming bad loans left and right.

reason contributor Jeff Taylor writes from North Carolina.