Jan122009

Bring Back Paternalism in the Mortgage Market

I do not like government paternalism. When Ronald Reagan came to power and began our 25 year experiment with government deregulation, I thought it was a good idea. It used to really annoy me when I would see paternalistic politicians who believed they knew what was good for me and for society, and that their ideas of right and wrong should be legislated. Government intrusions into the lives of citizens should be kept to a minimum, and citizens should have the right to make their own decisions and live with the consequences.Housing_death

Well, maybe not.

I used to believe all of that, but based on what I have witnessed during The Great Housing Bubble, I see good reasons to bring back a little government paternalism.

First, people are not willing to accept the consequences of their actions. People want the right to do what they want and obtain the benefits of their decisions when things go well, but as soon as things go badly, they want the government to bail them out. This goes for individuals, organizations, and entire industries. I have yet to see anyone step forward and say, “I screwed up, and I don’t think the government should do anything about it.” If gains are privatized and losses are collectivized, then there needs to be a paternalistic government regulator looking out for the collective interest. This means regulation and unpopular restrictions of the choices of individuals and organizations.

Second, even if people were willing to accept the consequences of their actions, sometimes these consequences have impacts on others who had nothing to do with the original decision. If every homedebtor accepted foreclosure, and if every lender accepted the losses without pleading for a government bailout, the economic consequences of their foolishness would still have enormous impacts on all of us who did not participate in the transaction. When people accepting responsibility for their actions still causes excessive collateral damage, then the activity should be regulated to save the rest of us.

Day after day on this blog, I profile properties where the borrowers have spent themselves out of their homes. There is a fascinating, “train wreck” quality to these stories. There are lessons to be learned about managing personal finances in general and mortgage debt in particular. However, most people will not learn these lessons. If given the chance, people will abuse their HELOCs, and lenders will extend the credit to people to allow them to do so. Without restrictions on mortgage equity withdrawal, people will spend their houses and lose their homes.

This conclusion is inescapable. The hundreds of properties I have profiled have clearly demonstrated this phenomenon is not isolated. The hundreds of thousands of foreclosures caused by refinancing and HELOC abuse are a testament to the depth and scope of the problem. If we do not change the system, we will see a repeat of this problem.

Some people are spenders, and some are savers. No amount of education is going to change that. Many of the outrageously pretentious spenders obsessed with conspicuous consumption are not going away. As I pointed out in Southern California’s Cultural Pathology, we have many spenders in our midst. These people will spend and spend until their creditors cut them off. Many are dealing with the painful reality of credit contraction right now. If these people were suffering in isolation and not asking for government handouts, I would be inclined to leave the system alone; however, these people are not suffering alone, and they are begging for the government to give them some of my money to support their foolish ways. This is where I draw a line.

Regulating mortgage equity withdrawal would not be a difficult endeavor. The only problem would be the resistance from individuals who want to spend this money and from the lenders who want this business. That will be some significant resistance. It would take something like a million foreclosures and an economic catastrophe similar to the Great Depression caused by this behavior to provide the political will to make this happen. Well… it looks like the political will might be there.

I would ban all forms of cash-out refinancing except for reverse mortgages and home improvement projects with certain restrictions.

There is no good reason for people to increase their mortgages to fuel consumer spending. Anyone who makes this argument because of the economic benefit of mortgage equity withdrawal obviously has not been paying attention to the fallout of The Great Housing Bubble.

Many will argue that cash-out refinancing to fund businesses is a good thing. Tell that to all the failed business owners who are also losing their houses. I believe it is much better to encourage new business start-ups to find capital from other sources. This will prevent a great many dreamers who do not have a viable business plan from doing something stupid that costs them their family home.

I don’t have an opinion about reverse mortgages. I do see where retirees whose home equity is their primary savings would want a method of accessing this savings. Given the power of the AARP, banning reverse mortgages is probably politically untenable. Perhaps we have to wait until the baby boomers get evicted in large numbers due to these loans before they will be reformed.

Anyone who builds their own house has gone to the bank for a construction loan. These loans require the borrower to provide receipts and other proof of construction progress before the bank will release the funds. There is no reason that HELOCs for home improvement cannot be done the same way. This ensures that the money is only loaned for property improvements. I would also limit this to 50% to 75% of the actual cost. Home improvement projects do not add value on a dollar for dollar basis despite the BS you see on HGTV.

Short of an outright ban on mortgage equity withdrawal — which I think is necessary to really solve the problem — I would propose limiting the home mortgage interest deduction to purchase money mortgages plus approved home improvement projects. If people did not get a tax break by adding to their mortgage, they might be much less likely to do so. If they want the HMID on a HELOC, they would need to go through the construction loan process as outlined above. Years ago, Congress eliminated the deduction for interest on credit card debt. When the lending industry created HELOCs and allowed people to consolidate debts, they effectively eliminated the prohibition on deducting credit card interest. Basically, with HELOCs, all interest can be deducted through loan consolidation. This must stop.

As a society, we have created a system that strongly encourages a borrow-and-spend mentality. Saving in all its forms are punished while borrowing is strongly subsidized and encouraged. The credit orgy of the 00s saw this system taken to its ultimate extreme. The result was a vicious credit crunch, a collapse in asset values, and an economic downturn second in severity only to the Great Depression. Obviously, something needs to change. A little paternalism in the mortgage market is one of a number of necessary regulatory reforms, and despite the idealism of my youth, I now support these reforms.