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Sanity Zone 10-25-2011 Bangulation Denied!

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Posted 10-26-2011 at 02:20 PM by xan

I have been having a running debate with one of my investment bank friends (call him Mike) about how to stimulate the economy. His essential premise is that below-water mortgages (where the value of the home is less than the outstanding mortgage) are causing banks to freeze lendable assets in anticipation of being forced to write down potential bad loans in the inevitable event of a homeowners default. If the government “covers” the portion of the account underwater and allows the bank to remark the value of the mortgage, then banks will then have no reason not to lend the capital that has been accrued for the potential write-down’s. This freed capital could be used to invest in new projects, growth, and ultimately more jobs. From a labeling point of view, this is a “supply side” and “monetarist” position, where capital constraints determine growth of the economy.

Mike’s solution won’t work in isolation. Consider these facts:

1)
There are about 4 million homes in inventory (not occupied) and there are many people trying to sell homes that are currently occupied (this number varies month to month).

2)
Demand for home ownership is at a 40 year low and trending lower. Renting is the more viable choice for most seeking housing solutions. Putting savings into an illiquid and depreciating asset for 94% of Americans would be a poor choice (note the understatement).

3)
10% of our economy is tied to the construction industry, both commercial and residential.

4)
There are nearly 18 million unemployed people, a significant number of whom provide construction services or were employed in construction related businesses.

Putting aside the facts above for one second, a family that is able to make payments on an existing mortgage are unlikely to default (and then possess terminally bad credit for at least a decade) just to avoid a current paper loss to their asset. The family would lose the tax deduction, and cause themselves to incur higher monthly rents and interest payments than they would if they had good credit. So, while there is risk to the banks on those below water mortgages, those mortgages which are current in payments are not as risky as those in the next example.

A family that cannot make a payment on an existing mortgage is likely to be unable for 2 reasons. First, their mortgage is one of those exotic interest rate mortgages whose rate increased unexpectedly (few of those right now, as the rates are tied to 10 year treasuries which are at an all-time low). The second is that the family has no source of income that can cover the mortgage at all. Those unemployed from above.

For the unemployed, resetting the mortgage value won’t matter because the monthly payments can’t be made anyway. The bank will have to write down the entire mortgage amount. Ultimately, the occupied home will be counted in the growing unoccupied inventory number. This will depress housing prices further, causing fewer housing transactions. Depressed housing prices means that there will be no new construction. Just like today, only worse.

What will stop the spiral are construction jobs, since those workers make up a significant portion of the unemployed. Not housing, but infrastructure. Infrastructure projects tend to be long term projects, employing many thousands of highly skilled workers. There are several hundred fairly large scale construction projects across the country that have been identified as critical (like replacing bridges and sewer systems, electrical grids, etc), and some that are prospective (like high speed rail.)

Many unemployed construction workers would be rehired, causing more mortgages to be current. In addition, more people working means fewer people collecting unemployment insurance, which is deadweight on a deficit. Further, these wages will be used to increase demand for consumer goods and services. Increased demand for consumer goods and services will stimulate hiring in industries that provide them. Increased employment usually, but not simultaneously, correlates with people buying houses. Housing inventories will decrease, and in some areas, require additional housing. Some of the underwater mortgages will flip above water. For those interested in labeling, this is pure Keynesian, or “demand” side economics. Note that unemployment insurance is NOT Keynsian. Transfer payments do nothing to help grow an economy.

My investment banking friend’s bank asset reset solution will only work where there are a huge number of houses for which there will never be enough demand to fill. Those areas are easily identifiable, Las Vegas, Florida, Arizona, and parts of California.

Because unemployment is a nationwide phenomena and the primary real estate issue is isolated to a few areas, a broader scale demand side program must be implemented before any supply side relief will be effective. (One cannot reasonably argue that resetting mortgages in overbuilt Las Vegas will increase job growth in Georgia). Without demand for housing, all there will be is an endless cycle of resets, and the government will ultimately own either the assets or mortgages as banks foist risk into this reset program. More government debt from this bailout will only be problematic as employment (and thus tax revenues) shrink. Sound economic policy depends on balance, and Mike's plan further tilts the scale toward supply side solutions that cannot be successful without sustainable demand.
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