Holes in the Roof

Monday, May 19, 2008

HOUSE FINANCIAL Services Committee Chairman Barney Frank (D-Mass.) has acutely summarized both the "systemic risk" posed by the housing market's decline and the "moral hazard" posed by a government fix: "The economy has been taken hostage by people that took some very bad decisions," Mr. Frank said. "The answer is to pay as little ransom as possible to the least ill-deserving people we can find."

But can he get that calculation right? Mr. Frank's housing rescue plan, which has passed the House and is being massaged by the Senate Banking Committee, would let the Federal Housing Administration refinance distressed borrowers into government-guaranteed loans worth up to $300 billion. Homes would get a fresh appraisal to account for slumping prices, and the lender would settle for 85 percent of the newly determined value -- well below the current principal balance, in most cases. That's the lender's "haircut"; as for borrowers, they would have to meet eligibility requirements and pay the government some of any profit they might ultimately make. Total cost: $1.7 billion over five years, according to the Congressional Budget Office.

In an election year, there's a lot of political momentum behind this bill. To win support from the Bush administration, which has turned hostile toward the idea in recent days, Mr. Frank has cleverly twinned his proposed mortgage bailout with tighter regulation of Fannie Mae and Freddie Mac -- a necessary reform long favored by Republicans. Federal Reserve Board Chairman Ben S. Bernanke thinks that the housing market needs principal write-downs. And we agree that preventing further damage to the economy is a valid reason to consider a bailout.

Still, we have our doubts. Economists forecast about 1.4 million foreclosures this year. The CBO estimates that Mr. Frank's bill would help about 100,000 borrowers a year over five years -- some of whom would eventually default again. Even if Mr. Frank has selected "the least ill-deserving" homeowners, some of their neighbors who did not live beyond their means are bound to ask, reasonably, why their taxes should help out the less provident and their lenders. Or they might demand the same deal. It won't be easy for Congress to tell them no.

In terms of systemic risk avoided, the bill may be oversold. Mr. Frank's program is voluntary, and, while banks might find it an attractive way to shift their worst credit risks to the government, owners of mortgage-backed securities are hardly clamoring to take him up on it. There's almost nothing in it for the holders of securities backed by second liens, a common feature of subprime loans. To be sure, the more home prices drop, the more lenders would participate, but that would leave the U.S. government on the hook for shakier loans, thus driving up the program's eventual cost.

In the Senate, Banking Committee Chairman Christopher J. Dodd (D-Conn.), who backs the concept, is negotiating with ranking Republican Richard C. Shelby (R-Ala.), a skeptic. The compromise they are discussing -- paying for the homeowner bailout by taking Fannie Mae and Freddie Mac funds set aside for low-income housing -- raises a serious fairness problem, too. No doubt the sprawling, subsidy-riddled housing market is in a lot of trouble. So far, it's less certain that Congress can figure out a way to fine-tune it.

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