Friday, March 28, 2008

U.S. Housing Crisis and Government Intervention

Government intervention into the U.S. housing crisis has become an issue in the ongoing presidential race. McCain, Clinton, and Obama have each made statements about how the crisis should be handled. I find that my opinion on this matter shifts depending on who I focus on. Let me go through some hypothetical players so that I can show you what I mean.

Case 1: Irresponsible Homeowner

Carl saw his friends making money from rising house prices and decided to buy a condo to get in on the action. He chose a condo selling for $280,000, but he couldn’t really afford it on his modest income. In an obviously shady arrangement at the height of mortgage excesses, he managed to get a mortgage for $300,000 with only half-size payments for the first year.

Carl knew he couldn’t afford the higher payments after the first year. His plan was to profit from the increased value of his condo in a year by either selling it or renegotiating his mortgage based on the new condo value.

Things haven’t worked out very well for Carl. He can only get $150,000 for his condo, but he owes $310,000 on his mortgage and he can’t afford the payments. Carl is going to lose everything.

With Carl in mind, it’s hard to see why the government should do anything. He took a wild chance based on greed and lost. He deserves what he gets. Helping him would be a waste of public money.

Case 2: Responsible Homeowner

Judy and her husband saved for years and finally bought a home two years before the housing boom peaked. The price was a bit of a stretch, but they could handle it on their two incomes. They got a standard mortgage from a responsible lender. A year later, Judy’s husband lost his job. But, they have just barely managed to make the mortgage payments anyway.

Judy would be able to continue this way if the mortgage payments stayed the same, but if the crisis keeps getting worse, lenders may start to raise interest rates causing Judy to lose her home.

It is easy to see why it makes sense for the government to intervene to make sure that people like Judy stay afloat. If too many people like Judy get forced into bankruptcy, it would cause huge social problems.

Case 3: Reckless Lender

The people working for WildCapital knew a good thing when they saw it. They could make huge commissions selling mortgages to people who couldn’t really afford them. And as long as the housing prices kept rising, their reckless lending wouldn’t lead to foreclosures and the party could continue.

Now that the bubble has burst, WildCapital’s customers have given up their homes, and WildCapital is left owning houses whose total value doesn’t come close to covering their debts. WildCapital is about to go bankrupt.

Good riddance. Bad companies should go bankrupt. A huge part of the ongoing success of the U.S. economy has been that good companies thrive and bad ones disappear. WildCapital should not be bailed out by the government.

Case 4: Responsible Lender

SteadyCapital refused to lower its lending standards through the housing bubble. As a result, they lost a lot of business to companies like WildCapital. What’s worse, SteadyCapital is at risk now if the crisis spreads to its customers like Judy.

It’s clear that the government should step in to protect customers like Judy and companies like SteadyCapital. But, the assistance should not be so great that it saves WildCapital. Otherwise, the government is essentially subsidizing WildCapital so that it can continue to steal business away from SteadyCapital.

What to do?

One hard part in all this is to figure out which borrowers and lenders are reckless and which are responsible. Another hard part is to figure out what sort of government action will have the desired effects.

Throughout all the political discussions from the three presidential hopefuls, I can’t tell which course of action is best. I welcome any comments that might help with figuring this out.

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