Apr122017

Will you pay for your neighbor’s reckless borrowing and spending?

When borrowers and lenders petition the government for relief through debt forgiveness and bailouts for losses, you are the one paying for whatever the borrower did with that money; the government is merely a middleman facilitator of a tax heist.

In a bygone era, lenders lost money if they made bad loans to irresponsible borrowers. With the advent of securitization, much of this risk of loss transferred to investors, and with the economic catastrophe of 2008, lenders learned the government would bail them out for any losses they were unable to pass on to investors. The too-big-to-fail banks no longer attempt to conceal the moral hazard behind their actions; they know they will be bailed out, so they act accordingly.

The worst example of moral hazard for both borrowers and lenders is the attitude toward mortgage equity withdrawal. Borrowers look at HELOCs as free money because they expect the house to pay it off. Lenders look at HELOCs as high-yield investments with little risk because they also believe the house will pay it off. All the manipulations of house prices, loan modifications, and other measures merely embolden both parties to be more irresponsible than ever — the worst part is that you will end up paying for it either directly through taxpayer bailouts or indirectly through inflated house prices.

Why will you pay your neighbor’s bills?

If your neighbor asked you to pay for the renovations to their kitchen, would you pay it? If they asked you to pay for their vacation, would you pay it? If they asked you to pay for their cosmetic surgery, would you pay for it? Well, if they purchase these items with a HELOC and stiff the bank who then gets a bailout, you do pay for it.

When borrowers and lenders, parties ostensibly entering into a private contract, can petition the government for relief through debt forgiveness and bailouts for losses, you are the one paying for whatever the borrower did with that money, the government is merely a middleman facilitator of a tax heist — dollars move from your pocket, through the government coffers, and to the bank that funded the Ponzi. So how do you feel about that?

Does it give you a warm and fuzzy feeling about a return to unrestricted mortgage equity withdrawal?

What’s worse is that economists and politicians want to see this behavior because they subscribe to the belief in the wealth effect, the most dangerous euphemism in economics. The conventional interpretation is that rising house prices make people feel more confident than rising stock prices, so rising house prices have a greater impact on people’s desire to spend, a partially true interpretation because prior to the housing bubble, house prices had never gone down while stock prices had crashed repeatedly. A rising house price appeared more stable; however, that isn’t what’s really going on.

If stock prices go up, people don’t have ready access to that money, as they would have to sell some of that stock and pay taxes on the gains in order to obtain the money. That’s work; that’s a hassle; that’s why the correlation between stock price gains and consumer spending is so weak.

If house prices go up, it’s a different story. When credit is loose, lenders will loan 100% of the value or more of a house with a HELOC or second mortgage, giving homeowners immediate access to cash, and it doesn’t have any tax implications — and the owner doesn’t have to sell the house, so they may be offered even more free money in the future. That’s easy; that’s convenient; that’s why there is a strong correlation between house price gains and consumer spending.

What about home improvements?

Home improvement is the only use of HELOC money that’s justifiable, but most people do that improperly. A typical renovation project adds about $0.60 for each dollar spent because a homeowner typically is renovating to their tastes rather than renovating only what adds value.

What about debt consolidation?

Using HELOCs for debt consolidation is a crutch. Financial advisors condone this because consolidating high-interest short-term debt with low-interest long-term debt lowers a borrower’s payments; however, the borrower shouldn’t have borrowed so much on credit to need the consolidation in the first place.

Should HELOC lending be restricted?

As long as HELOCs are limited to 75% or 80% of the value of the home, it doesn’t become a problem. In fact, Texas largely avoided the housing bubble because it prohibits HELOCs above 80% LTV; with no access to HELOC money, Texans had no incentive to drive up home prices, particularly given the high property taxes there.

We have the opposite here in California: we have no restrictions on HELOC lending other than what the banks impose on themselves, and we have low property taxes capped by Proposition 13. Californians have every incentive to drive up home prices to create fake wealth, and no tax disincentive to dissuade them. Our HELOC availability and property tax regime is a recipe for house price volatility.

Lenders were bailed out when the housing market collapsed in 2008; they were given direct assistance through government bailout funds, and they were given indirect assistance through a variety of government and federal reserve programs designed specifically to reinflate the housing bubble. The costs of these bailouts fall to you in one form or another; either you pay through your taxes, or you pay through your mortgage on a more expensive house.

As with the moral hazard of these bailouts firmly in the minds of borrowers and bankers, I expect we’ll see another even more massive housing bubble again in the future. It’s only a matter of time.