Three Things That Won't Help End the Foreclosure Crisis

Falling home prices, rising foreclosures rates, and a slowing economy have created a perfect storm for homeowners who bought in bubble-inflated markets, or used subprime, adjustable-rate mortgages to purchase their homes.

Members of Congress have responded to the crisis facing their constituents by proposing various measures, some strong, like amending the bankruptcy law to cover primary residences, and some misguided. The following are three major proposals that would actually do more harm than good. As Congress seeks to pass legislation to stem the foreclosure crisis, legislation containing elements of these proposals should not be on the table.

1. Subsidies for Home Buyers

Homeownership can be a useful way for families to accumulate wealth and to provide good secure housing. However, if families are buying homes with bubble-inflated prices, then they are not likely to accumulate any wealth in their home, since the price is likely to fall back to its trend level before they sell their home. (The median period of homeownership for moderate-income families is just four years.) Furthermore, they are likely to pay far more in housing costs each year, than they would to rent a comparable unit.

In the case of moderate-income families facing serious budget constraints, the additional housing costs associated with owning an over-priced home are likely to come at the expense of other necessary items, such as health care and child care. It is difficult to see how the government will have helped a family by encouraging them to buy into such a situation.

Additional tax credits for home buyers in a bubble-inflated market can put more people at risk by encouraging them to buy an over-priced home that will fall in value. In addition, tax credits for the purchase of homes that are in the foreclosure process, but have not yet been returned to the lender, provide a perverse incentive to lenders to foreclose on current homeowners, since they increase the resale value of the house following a foreclosure.

2. Artificial Price Floors

This has nothing to do with linoleum, and everything to do with how prices get set for homes that are refinanced and backed by FHA loans as proposed in legislation being considered by Congress.

If home prices continue to decline, and the government issues guarantees of mortgages at prices that are near current levels, then the government is likely to face a substantial cost associated with a high default rate. The most important factor determining both the default rate and the cost of each default is the movement in house prices.

If prices continue to fall, then many homeowners will again find themselves owing more than the value of their home. This situation leads to defaults for two reasons. First, if a homeowner owes more than the value of her home, then she does not have the option to borrow against equity in order to make her mortgage payments. This eliminates an important source of security if job loss or unusual expenses leaves the homeowner temporarily unable to pay his or her bills.

The other reason why this situation increases default rates is that homeowners who owe more than the value of their home can effectively save themselves money by simply surrendering their house to the bank. If a homeowner owes $200,000 on a home that is currently worth $180,000, the homeowner can effectively save $20,000 by just giving the house back to the bank. While this move will hurt the homeowner's credit rating, if they don't have any special attachment to the house, a homeowner may choose this option.

In addition to increasing the number of defaults and foreclosures, falling house prices will also increase the loss on each foreclosure. If the house is still valued at close to the amount of the mortgage, then the losses on the foreclosure will just be the administrative and transactions costs associated with carrying through the foreclosure and reselling the house. However, if the house sells for less than the value of the mortgage, then this can be a substantial source of additional losses for the government.