If to Err is Human, is Forgiveness Really Divine

It is clear that the financial crisis that began in the US housing market and the derivatives tied to it has metastasized well beyond it, but it remains in the forefront of policy makers concerns. And for good reason, home ownership in the US reached almost 70% before the recent surge in foreclosures. An estimated 1% of homeowners were in some stage of foreclosure proceedings at the start of the year.

The Bush Administration has launched several initiatives to help relieve the pressure on American home owners, including the Hope Now private sector effort to minimize foreclosures. Nevertheless, as foreclosure rates rise, political and economic pressure mounts to do more.

Debt forgiveness is not something one often hears from policy makers in the United States, who often eschew efforts to escape the discipline of market forces. It is something reserved for the highly indebted countries or something associated with anti-capitalist leftists. Yet this is exactly what several senior US policy makers are advocating.

The Chairman off the Federal Reserve Benjamin Bernanke, the director of the Office of Thrift Supervision John Reich, and the Chairwoman of the Federal Deposit Insurance Corporation Sheila Bair. all are advocating that mortgage lenders should do more about writing down the principal.

Bernanke, who enjoys arguably the greatest degree of insulation from political forces, was explicit. “Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquencies and foreclosures” than the current efforts by the government and private sector.

This represents a clear evolution of his thinking. A year ago he was trying to reassure the market that the subprime problems were contained. He initially proposed tighter regulation to stop abusive lending practices. Even as recently as late February, the Federal Reserve advised pursuing prudent loan workouts through modifying mortgage terms and deferring payouts.

In contrast to Bernanke et.al. moving to including principal as part of the efforts to stabilize the housing market, Treasury Secretary Hank Paulson continues to emphasize renegotiation of interest rates. Indeed, while the head of the Fed, FDIC, and OTS are concerned that house values falling below mortgage values poses serious problems, Paulson seems nonchalant. On March 3rd, Paulson told a Bloomberg Television audience that “almost too much” has been made out of concerns for homeowners whose house price had fallen below their mortgages.

This is not to suggest that Paulson cannot be moved. Last year he opposed raising the $417k mortgage cap Fannie Mae and Freddie Mac could buy to package into bonds. Earlier this year he agreed to it. In seeking to explain his reversal, rather than say the housing problem had worsened he blamed politics. He had been “run down by a bipartisan steamroller.”

The national election is only 8 months away. Politicians from states that have high delinquency and foreclosure rates and falling home prices may be more inclined to push the envelop for their constituents. Of course, there is a push back from lenders and their related lobby groups. Bernanke recognized this and tried to address their concerns.

“Lenders tell us”, he said that they are reluctant to write down principal.” They argue that it is a slippery slope. If they were to write down the principal once and house prices fell further, they could feel pressure to write down the principal again. Yet Bernanke tried appealing to their own self-interest: by reducing the loan amount, they would reduce the risk of default and foreclosure and thereby increase their expected payoff.

Paulson seems fairly cool to the idea. Although he seems to recognize that under some conditions a lender may indeed find that writing down part of the principal is less costly than a foreclosure, Paulson did not seem as prepared as Bernanke et.al. to use the “bully pulpit” of his position to encourage the exploration of such an option.

Bernanke seems prepared to even go further. He has suggested that it is worthwhile to consider the use of government funds to support the housing market. Paulson was quick to demur and claim it was a non-starter.

And perhaps it is with him at the helm of the Treasury, but regardless of the outcome of the November presidential election, Paulson will not be in that position a year from now. And in the meantime, the situation continues to worsen, judging from the trend in the poisonous cocktail of falling house prices and rising delinquencies and foreclosures. Some estimates warn that there may be as many as 2 mln foreclosures this year. In 2007, industry figures show roughly 2.2 mln default notices were delivered and 1.3 mln auction notices and bank repossessions.

Of course there will be some to dismiss the direction that Bernanke et.al. seem to be moving in, but surely they cannot be dismissed as radicals or in some way anti-capitalists. They recognize the enlightened self-interest of lenders may support such an unorthodox approach.

Some market fundamentalists may cry “moral hazard”, but at the root of the problem was another moral hazard that they did recognize and that is that the underwriters did not carry the loans on their books. The time to cry moral hazard is not when the fire department is trying to put out the fire. The reforms that will likely be forthcoming will seek to prevent a repeat of the behavior that got us into their mess in the first place.

Other market fundamentalists will argue that government should not have a role in the housing market. Yet it does in very profound ways: from the tax break on mortgage interest, to the government-sponsored agencies that buy the bulk of conventional mortgages, to loans under the Federal Home Loan Bank. It’s a bit disingenuous now to cry interference in a free market.

If we believe that democracy works best when ownership of property is widespread, and home ownership is seen as an important value transcending the narrow economic rationale, then it is in the national interest to prevent the kind of dislocations and disruptions that the housing market collapse may represent if it is allowed to continue. A scorched earth strategy might appeal to some fundamentalists, but it is a very dangerous path to set upon. If attempts to stabilize the situation are rejected both more hardship and more radical proposals will be forthcoming.