Saturday, March 6, 2010


In a recent Newsday Op-Ed article, former Secretary Reich supports President Obama’s plan to assist homeowners who have mortgages for amounts greater than the homes value (underwater). A short fable is instructive:
Mr. Ant and Mr. Grasshopper have identical jobs. They buy identical houses for identical prices. The only difference is that Mr. Ant uses his savings to make a 50% down payment; Mr. Grasshopper gets a mortgage from a bank for 100% of the purchase price. The value of their homes goes down 50%. Mr. Ant has lost the equity in his house (his savings); Mr. Grasshopper has lost – nothing.

Enter the Reich/Obama solution to have the bankruptcy court adjust Mr. Grasshopper’s loan so he is no longer underwater. Mr. Grasshopper has not lost any of his own money; Mr. Ant’s savings have been wiped out. But the plan assists Mr. Grasshopper while Mr. Ant gets - nothing. Besides helping the wrong guy, Mr. Reich does not explain how this will help recovery.

An interesting byproduct occurs when the value of both homes goes back up - say 25%. Mr. Grasshopper now has 25% equity in his home; Mr. Ant has now lost only part of his savings.

Secretary Reich does not even propose that this would help that housing market; nor does he suggest that it would free up credit. In fact, it would restrict the availability of credit. Invalidating lending contracts will not encourage more lending; nor will destroying the value of contracts help businesses recover.

The only rational they offer for this “solution” is punishing the banks - a popular pastime but not a solution. The reason for all of this is that the banks were encouraged through Fannie Mae to make loans with little or no down payment. (The banks screwed up but they were certainly encouraged to make these subprime loans.) Fannie Mae and Freddie Mac own most of these loans and the federal government owns both of them. This plan will be successful in hurting the banks but will also reduce the value of the government’s own assets.

Reich’s reasoning is that the President should “work for everyone” to help those who are underwater. But his proposal will work best for people who didn’t save for their home and will not work at all for those that did. The more money people saved to make a down payment, the less likely they are to be underwater and so would be ineligible for this program. It encourages the wrong behavior.

Further, the fact that the value of a home goes down does not mean that government assistance is necessary. Any such program should ask questions: Was there a down payment? Was there a cash out refinance (where is that money)? Is it an investment property? Eliminate all of these. See what is left. Act to help people who are unempoloyted.

President Obama said multiple times during the campaign that he was going to redistribute wealth. He is, unfortunately, honoring that pledge.

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