New Housing Bailout - The Osman Plan

by Osman Parvez
A few weeks ago, my parents were visiting from upstate New York. At some point, we had an intense discussion about bailout and economic stimulus efforts. I argued that enormous amounts of liquidity were being "injected" into the financial system by central banks, but it wasn't addressing a fundamental problem. Housing was still way too high in the former bubble markets and yet prices were continuing to collapse.

My idea was simple. Use the GSE's (Fannie, Freddy) to underwrite new low, fixed rate mortgages to highly qualified buyers in select zip codes. My recently built investor model (soon to be discussed on the blog) showed that return was very sensitive to mortgage rates. A low fixed rate (say 3%) would put a floor under the housing market in the worst hit areas. Investors (with high credit ratings, strong incomes, and a prudent amount of equity) could swoop in and convert these homes back into rentals. Because it would be selectively applied and temporary, it wouldn't re-inflate a bubble but it could stop the free fall in prices. The government could even layer in tax incentives, like accelerated depreciation and temporary tax credits.

My father, eventually agreed that it sounded like a good idea. Then he asked, "What are you going to do about it?" He suggested at least submitting it to the incoming Obama administration.

At first I was reluctant, but with "yes we can" in mind and spirit, I did. And what do ya know? A few months later, voila!

According to the WSJ, the Treasury Department is considering a new plan.
The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.

Government officials are under pressure to address falling home prices and mounting foreclosures, which underpin the financial crisis. The Treasury has struggled for months to come up with a plan that would ease the strains on borrowers without appearing to bail out homeowners and lenders.
The devil is in the details but I think this plan could actually work. Yes, yes... I know my submitted idea is probably sitting in a digital vault among million of unread suggestions for President-elect Obama, but I like to think that somebody read it and realized its brilliance. I might even have to call it the Osman Plan.

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  1. Your premise is: "Housing was still way too high in the former bubble markets and yet prices were continuing to collapse." So, instead of letting prices fall further you want them way too high.

    I posit, if gasoline prices (coming off a former bubble) were way too high and yet prices were continuing to collapse, then you would propose to give car owners a below market credit card rate to support gasoline prices? Why not let people buy gasoline or a roof over their head when the economics justify it, rather than support a false price?

    What is wrong with house prices falling to their natural equilibrium point (or temporarily below) where buyers say, you know what, I'm going to stop renting and buy? Demographics point to lower house prices in the future. There is no reason to support the unsupportable.

    Note that future homebuyers have changed their mantra from:
    a) if I don't buy now, house price will runaway and I'll never afford it or
    b) if I get as big a loan as possible from the bank I can leverage up, and look how much I'll make in capital gains in 5 years time;
    People are actually going back to basics and saying, what is my buy vs rent equation, what is my real affordability level, what is the utility in buying this house vs other items, how much more time and effort will I need to put into maintaining a house vs simply renting?

    The moral hazard risk of bailing out all these homeowners, auto companies and financials is rising exponentially. It has been proven time and time again around the world that government bailouts are inefficient to the tune of 8% GDP loss on average crisis vs countries that did not bailout. Capitalism on the way up and socialism on the way down is not a prescription for allocating resources to producing what is necessary in the future.

    You have the right to your opinion, but I could not disagree with you more.

  2. Excellent comment Linton.

    Yes, in an indirect way, if you put a floor under all those houses with falling prices (in former bubble markets), you run smack into moral hazard. This concerns me but at the same time if we don't do something to support falling prices, there are critical implications.

    It boils down to whether you'd rather inflate or deflate your way out of this asset bubble. And remember, this bubble is not just about a commodity like gas. Housing is central to the economic well being of most Americans, and it's also central to our economic system.

    The question is also what's the role of government? I think actions that help keep people employed (paying taxes), selectively supporting certain players (AIG) while allowing others to fail (Lehman, maybe GM and Chrysler) might be the right course of action. A blend of incentives to encourage investment in housing when house prices are falling off a cliff, threatening to take the economic system with it and destroy the well being of so many... is also right.

    The government has long been involved in housing. Without government involvement, we'd be paying outrageous financing costs to own a home. Clearly disconnecting underwriting from the risk of owning a mortgage asset was a mistake, but that doesn't mean we should throw everything away now. Low interest rates did make housing more affordable for many.

    As it happens, I live in a small house that was built for WWII GI's. My little house is the result of yet another government program. When the soldiers came home, the economy transitioned to peacetime and the government was wise enough to create programs that laid the foundation for the next 50 years of economic prosperity. Shouldn't it do something now?

  3. Linton is 100% correct. You can not pull levers and control the markets. Every single bail out has unintended consequences, and the market instantly figures out how to work around the new rules, for example; turning yourself into a commercial bank in order to get cheap .gov loans (hmm..Goldman, MS, and countless others). I am sick of being fleeced by bankers.

    This is insane, let the damn market work already! Cheap housing is good for America, cheap food, cheap gas, all good.

    Osman you seem to think there is a choice between Inflation or Deflation, and you are wrong. You can't push the zero key on the Federal Reserve computer fast enough for monetary inflation to overpower the defaulting of debt.

    In order for that "printed" money to enter society it must be borrowed and lent. No prudent bank will lend money to an over leveraged America, and like wise, an over leveraged America is not looking to increase it's leverage by borrowing. Have you heard the expression "Pushing on a String" This is called money velocity, and there is absolutely none right now. The money simply is not penetrating to Main street, it is filling giant holes in Wall street balance sheets, where it stays and dies. The exponential effect of fractional reserve lending is not allowed to happen.

    Asset values will decrease until their equilibrium is found. If you want to put a false price under them, then shame on you, because that is not what's good for America in the long run. Sustainability is what is needed, not living with a mortgage you can't afford, or putting off our debt to our kids.

    You say you are against creating moral hazard, yet you call for more bail outs, which reward losers and penalizes winners. This has never worked, it in fact unravels the very fabric of society, and leaves everyone with their hand out wanting their "fair" share too!

    It is exactly this behavior that has gotten us to where we are today. I recall hearing Allen Greenspan testify to Congress just a few months ago, where he said that his economic philosophies were flawed and that trying to control the growth of the economy though controlling interest rates and other stimuli did not work.

    Please oh please, just stop trying to control the market, and let the damn thing work already.

    As it is very late and my brain is not working anymore, I bid you good night, that is all.

  4. Philosophically, I agree with you but we aren't in a free market. The "no action" choice is wishful thinking and unrealistic. Governments around the world are already acting.

    Up until the plan Treasury proposed yesterday, there hasn't been one I even partially supported. The previous plans were being sold on urgency. I'm suspicious of anything you must buy now, before opportunity disappears, like junk sold in an infomercial. Junk they've turned out to be.

    From what I understand, this proposed plan is about income, asset, and credit qualified buyers getting a lower fixed rate mortgage to help mop up excess inventory. It doesn't have to be a radical departure from the existing system of mortgage financing and securitization. Lending to borrowers who pass strict underwriting standards is not pushing a string.

    Underlying this conversation is a belief about the rightful place of government. So I'll ask again, what do you think is the role of government? Should government stand by as millions of homes foreclose, jobs are lost, and we enter a protracted and extremely painful depression? Should government be paying farm subsidies, creating tax incentives, or directly investing in new technologies?

    Look, a deflationary cycle will feed on itself. What's the floor? Will the price of reaching a "natural floor" (whatever that is) destabilize our government and the fabric of society? As much as I love the philosophy, I'm not sure I'm ready for a battered and bruised America, with high unemployment, little ability to generate wealth, and widespread crime. I think allowing this crisis to unfold without action is dangerous.

    By the way, nothing will usher in radical change faster than a complete economic collapse. We may already be heading there. Fasten your seat belt.

  5. Osman, your parents were simply right in the first place. Here's an example of a money transfer in the Treasury plan:
    Suppose a seller lists a house for $1,100,000, but today's market price is $1,000,000. Under current market conditions if the seller reduces the price to $1,000,000, the seller is out $0 from the market price, the realtor is out $0 from the market price, the government (taxpayers) is out $0 and the buyer is out $0, since he/she can resell for the $1,000,000 market price.

    The Treasury Dept plan sells this to us as they will subsidize interest rates, so that a new buyer saves 10% on the mortgage. Under the same circumstances, the buyer now pays $1,100,000, because the effective cost is $1,000,000. The seller pockets $94,000 extra, the realtor pockets $6,000 extra, the gov't (taxpayers) lost $100,000 and the buyer is left with $0. The buyer received $0, because that is the difference between seller, realtor and gov't.

    Unless flipping the house, this new gov't program will expire before the buyer ever gets a chance to sell the house, so taking identical market conditions, the buyer (now a new seller) will receive $1,000,000 for the house he/she paid $1,100,000 (or supposedly $1,000,000 if loan held to maturity). So unless loan held to maturity, the buyer is not even break-even in this situation, because they originally paid a higher price than the real market rate.
    This is a perk for sellers and realtors only, and is negative for buyers and especially taxpayers. Sellers reduce prices to the market's economic equilibrium or lower and the buyers will come.

  6. The fallacy is in thinking that artificial stimulation will help. Infrastructure, creating sustainable jobs, and the like are examples of positive stimulus. Financial engineering and false prices never work.

    I am not completely rigid in the idea of not doing anything, but magical money printing or transferring debt from one hand to the other, is just a recipe for greater disaster.

    No matter what the government does we are going into a terrible recession if not worse, so using the few resources we have effectively is the key. Throwing money into the wind is what we have been doing, and that must stop.

    By the way, the global deflationary spiral has already started, and it can't be stopped, so prudent spending is even more important going forward.

    My seat belt is fastened and has been for sometime, so let's hope the crash landing isn't too rough.

    Try and have a great weekend, let's all stop and smell some roses, eh?


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