The pros and cons of a bailout

The Wall Street Journal's David Wessel argues that if the government does anything about rising foreclosures due to unaffordable loans and negative equity, the Barney Frank plan about to be vetoed by the Bush Administration might be an experiment worth pursuing:

The latest flash point in the debate over the nation's bursting housing bubble is this: Since so many American houses are worth less than their mortgages, should the government do more to get lenders to settle for less than the full debt, even if it may cost taxpayers some money?

The White House and Treasury say "No!" House Financial Services Committee Chairman Barney Frank and other House Democrats, with the quiet backing of Federal Reserve Chairman Ben Bernanke, say "Yes!"

Of the 80 million houses in the U.S., about 55 million have mortgages. Of those, four million are behind on payments. Foreclosure proceedings were begun on about 1.5 million homes last year, up more than 50% from 2006. This year will be worse. The Treasury, according to presentations its officials have made recently, predicts house prices could fall another 10% to 15% before touching bottom.

Moody's Economy.com estimates that one in roughly 12 American families with mortgages -- four million in all -- already owe more than the current value of their homes. They are said to be "underwater." The firm predicts that by early 2009 nearly one in four, or 12 million, homeowners will be underwater. Most will continue to pay mortgages on time. Many won't, and are at risk of losing their homes...

In ordinary times, a lender shouldn't need prodding from the government to do what's in its self-interest. But these aren't ordinary times. The drop in home prices is pervasive, mortgage markets messy and complexities caused by turning mortgages into securities many. No one in Washington wants to help the "speculators" who bought homes they don't live in or those who lent to them. And there's broad agreement that those who bought more house than they'll ever be able to afford are going to lose out. The debate revolves around the "preventable foreclosures."

Mr. Frank would offer lenders and eligible borrowers a deal: If the lender agrees to cut the debt so the homeowner owes no more than 90% of the house's current value, and the Federal Housing Administration (or an outfit to whom it outsources this) determines the homeowner can afford a new loan, then the lender gets rid of the mortgage and the FHA insures a new mortgage for the remaining balance.

The lender takes a hit, but gets rid of the risk that house prices will keep falling or the borrower will default on a new loan; the government picks up that risk. To create a cushion for the FHA, the lender has to chip in another 5% of the property's current value. The homeowner has to surrender some profits, if any, to the government when the house is sold...

The White House condemns this as a "bailout" and says it won't work. As the Treasury argued in a recent PowerPoint presentation: "Homeowners who can afford their mortgage but walk away because they are underwater are merely speculators." (It's a bit jarring to hear the Treasury vilifying people who are acting in their economic self-interest.) But if not for the widespread decline in house prices -- "a relatively novel phenomenon," Mr. Bernanke labels it -- and the proliferation of no-money-down mortgages made with the acquiescence of regulators, these homeowners wouldn't be underwater.

Despite the restrictions, the plan could allow some homeowners to get a deal they don't deserve; that's the unfortunate byproduct of any rescue. But the Treasury and Fed surrendered the let-the-market-work-it-out high ground when they agreed to risk nearly $30 billion of taxpayer money to shield Bear Stearns, its creditors and counterparties from losses.

This scheme might not work. Mr. Frank has crafted rules aimed at preventing those who can easily afford loans and those who haven't a prayer of paying a new loan from participating, leading the Congressional Budget Office to predict only 500,000 mortgages would be refinanced this way. Some administration experts suspect that's high; they doubt many lenders will play ball. In that event, it won't cost taxpayers much.

So, perhaps it's best considered a prudent experiment for coping with a bad situation that might get worse: Create a mechanism now so the bugs are worked out, in case home prices plunge more than anticipated and push millions more homeowners underwater.