Thursday, April 3, 2008

What Gets Bailed Out in a Mortgage Bailout?

Congress is jumping all over itself (I do not recommend visualizing this metaphor) to get the most extravagant form of borrower mortgage bailout passed. Presumably, this will let the folks with the most egregious sub-prime loans convert them to something with less rate escalation.

But weren't the sub-prime loans originated with little or no equity? If so, then they're almost certainly underwater with little or no sunk costs. So reducing the interest rate has only marginal utility. The "owners" can bug out whenever they want by mailing in the keys and taking the credit hit. They suffer no direct financial consequences by walking away, lower rates or not.

The picture gets a little better with owners who had equity in their homes initially, even though the decline in prices has wiped it out. At least these folks have some sunk costs, which, however irrational it might be, will tend to make them want to stay in the house and hope that prices go back up. Seems like any bailout should be targeted at this population of homeowners.

In an earlier post, I'd recommended relieving defaulters of the adverse credit reporting consequences of walking away. Based on the above, this would be an incredibly bad idea. At this point, we're really looking for ways to incent people to stay in underwater loans and tough it out.

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