Subsidizing Housing for Homeowners

DATE: February 24, 2011

TO: redacted

FROM: Scott redacted

SUBJECT: Subsidizing Housing for Homeowners

SUMMARY

The Obama administration is pushing for a settlement with home mortgage servicers which would require them to grant principal reductions to homeowners. Only those homeowners who owe more than their house’s current market value will benefit. This paper looks at whether this or similar efforts will benefit the slumping housing market. The inappropriate nature of the plan as well as its implications is considered as well.

INTRODUCTION

The U.S. housing market began a massive slump beginning near the end of 2007, a time which many declare was the bursting of a housing bubble. Month after month since that time, the number of foreclosures has been at exceptional highs. High unemployment and a record recession have only exacerbated the problem. The banking industry has had serious difficulty dealing with the large volume of foreclosures. On the other side, the great number of homeowners who stand to lose their home has garnered much public concern. In response, the government created a program called HAMP (Home Affordable Modification Program) as part of the TARP.

In the February 24 issue of the Wall Street Journal, an article entitled “U.S. Pushes Mortgage Deal” describes a settlement being pursued by the Obama administration with mortgage servicers. This is from a case against the servicers claiming they improperly handled foreclosure proceedings. The settlement would force the banks who service those mortgages to award principal reductions to homeowners whose house’s market value is less than the amount owed.

ECONOMIC EFFECT

The outcome to the economy of any sort of principal reduction program is like that of a subsidy. In this instance, demand moves right, which will increase price and quantity. In a market where house prices have already reset ten to fifteen years, increased prices would be welcome. However, an increase in the quantity of houses would further exacerbate competition in the already flooded market.

For those homeowners who receive modifications, reducing principals would have an effect such that they would feel as though they can afford more house. Yet, in their cases, the “more house” would just mean they can afford the house they are currently living in (maybe.) Therefore, as long as they do not sell their home, there may be no effect on demand. From that perspective, no harm is done. Although, from the lender’s perspective, it is as though the borrower came to him for, say, $100k and received $110k, but still only repaid the first amount.

The subsidy effect would touch the market when those subsidized homeowners sell their homes. They will essentially be able and/or willing to sell their homes at a lower price than those homeowner’s who were not subsidized. The effect would be greater for those who sell within a year or so of receiving the principal reduction and diminish as more time passes.

An increase in construction costs could be another side effect. However, since the program would not (hopefully) go to the same homeowner more than once, this may not be the case.

Each party (banks, investors, homeowners, etc.) who has to accept all or part of the burden of any program designed to help foreclosing homeowners, such as principal reductions, will have an impact on the economy. Whatever portion banks bear (and according to the article it may be all) will return to the economy in reduced lending capacity, lower savings rates, and lower quality investment products as the banks work to recoup their losses. Whatever burden investors accept will show up in the economy through their reduced investing and spending.

For the proposed settlement, the banks themselves will be responsible, as servicers, for the entire amount. Investors will likely not take a part of the loss. It is curious that they would not. They were invested in a risk product, as apposed to a CD or government bond where returns are guaranteed. Potential losses are part of that risk. It seems that they should take a part of the loss along with the bank. Spreading the burden would have a smaller impact on the economy overall.

PSYCHOLOGICAL EFFECT

Along with economic effects, a principal reduction program can have psychological effects that may influence the market. The largest of these is the dangerous precedent it sets for any future housing market troubles. Once these types of measures have been taken to solve a housing crisis, it will be difficult not to revert to them in the event of another. Not to mention, once government programs get going, they are hard to end: even the supposedly temporary ones.

There will also be a negative effect on current homeowner’s in regards to their home and home value. As Diana Olick put it, most homeowner’s would rather see their “home's value go down than see the guy next door who made a poor/negligent financial decision get a mulligan” at their expense. Not to mention, if home values begin to climb back to any sort of profitable equity levels as it concerns those subsidized homeowners, there could be serious resentment from the homeowners who didn’t receive any help.

A last psychological effect will be the tendency to inspire more defaults. When other homeowner’s discover that there may be a financial gain to be had from letting their mortgage payments get behind, they may be inspired to join the foreclosure bandwagon.

ALTERNATIVELY

When HAMP was passed, it set a freeze on all foreclosures. Through various other measures from that bill, foreclosure proceedings since the bill’s passage have been stalled. As a result, the housing market is not being allowed to clear as it should. Consequently, the housing market troubles will only continue to worsen unless foreclosures are allowed to proceed as they normally would.

Even if housing prices were to return to their 2007 highs, as impractical as it would be, that hypothetical situation would really only benefit those mortgage holders who were speculators. This is because they would then be able to sell at a price that releases them from the financial burden without suffering a loss. Those who are genuinely having trouble paying their mortgage now, will not magically be able to start making payments just because their house’s value has increased. Sure, they also would be able to sell their homes. But they would be just as homeless in that hypothetical case as they would be if they went through a foreclosure now.

The point being, if homeowner’s are not able to make their mortgage payments, the best solution for everyone is to go through with the foreclosure. No one will actually be homeless, they will just become renters.

Banks should simply begin enforcing foreclosure as outlined in mortgage documents. Once it has become clear to everyone that there will be no chance of forbearance, debt reduction, principal reduction, or any other type of rescue, those borrowers who do have the means to continue paying their mortgages will do so. Those who truly cannot will have to face the reality of their situations.

The price correction needed to clear the housing market is a heavy weight. As mentioned above, it is better if the burden is spread among many, rather than a few. It will eventually be bore by the majority any way, but allowing market forces to perform as they should will bring us to recovery levels quicker.

The burden laid on individual homeowners will show up in different ways depending on how each homeowner handles their own situation. This will, of course, be dependent on each person’s financial situation. There will be those who keep their homes and those who have to let their homes go.

Those homeowner’s who, for whatever reason, are able to catch up their mortgage payments and keep their homes, their effect on the economy will be neutral to positive. Staying in their home will not affect the supply or demand for homes in the market. As investors in and maintainers of their property, though, they will have a positive effect on prices in the long run.

Those who genuinely cannot bear the burden of their mortgage will have to give up their home. This will result in a loss to the homeowner’s, the banks and the investors. The loss to the homeowner would be any equity they have in the property.** They may possibly face a higher cost of rent. Investors would lose whatever portion of their investment that cannot be recovered in a resale of the property. Banks would lose the income and fees received as servicers of the loans.

For the most part, there would surely be a net loss for everyone, but there would also be some gains for each party. No longer tied to their homes, the homeowners would regain mobility which may prove beneficial when seeking employment. For investors, where their money was once tied up in an unprofitable investment with sporadic returns, they would regain the liquidity to move their investment capital to better investments. The banks, it seems, have the least to gain. Their biggest positive would be freed up resources (personnel etc.) who were engaged in billing and foreclosure dealings with the homeowner.

Homeowners who have never had difficulty with their mortgage payments will also be affected as their home prices fall along with the entire market. This has already happened. On the positive side, they would gain the confidence of knowing that the crisis is over, the market is on track again, and the economy can reasonably be expected to begin an unimpeded improvement.

CONCLUSION

Instead of the constant government involvement intending to help homeowners stay in their homes, what the market needs is to allow foreclosures to proceed as they normally would. This is a natural function of the free market. It would not be easy on those directly affected and the effects would ripple throughout the entire economy. However, the result would be a quicker recovery for the markets, and a preservation of our economic freedoms.

Works Cited

"Calculated Risk: New Research on Mortgage Modifications and Principal Reduction." Calculated Risk. N.p., 6 Jan. 2010. Web. 2 Mar. 2011.

Ellis, Timothy. "Seattle Bubble Friday Flashback: Case-Shiller Home Price Losses Mapped." Seattle Bubble. N.p., 25 Feb. 2011. Web. 2 Mar. 2011.

Haughwout, Andrew, Ebiere Okah, and Joseph Tracey. Second Chances: Subprime Mortgage Modification and Re-Default. New York: Federal Reserve Bank Of New York, 2009. Web. 2 Mar. 2011

Olick, Diana. "Are Principal Writedowns the Answer to Housing Crisis? - CNBC." Stock Market News, Business News, Financial, Earnings, World Market News and Information - CNBC. CNBC, 6 Jan. 2010. Web. 2 Mar. 2011.

Timiraos, Nick, Dan Fitzpatrick, and Ruth Simon. "U.S. Pushes Mortgage Deal - WSJ.com." Business News & Financial News - The Wall Street Journal - Wsj.com. Wall Street Journal, 24 Feb. 2011. Web. 2 Mar. 2011.

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**For the homeowner’s equity, it would be noteworthy to know more about what comprises that equity. What portion of their equity is based on actual dollars paid towards the down payment and mortgage and what portion is a factor of perceived value as a result of increasing property values. Also, mortgage payments as a function of rent should be considered; putting mortgage payments on the debit side as an expense, rather than an investment. Equally so, this same type of analysis would be of note from the investor’s perspective. In other words, how much of each party’s real values will be lost in a foreclosure. Then, the true economic impact could be assessed more clearly.

Is There Economic Justification for Public Funding of Broadband Internet?

DATE: February 24, 2011

TO: redacted

FROM: Scott redacted

SUBJECT: Is There Economic Justification for Public Funding of Broadband Internet?

SUMMARY

An article in Businessweek entitled “The Flaw in Obama’s Wireless Plan” discusses the benefits of choosing wireless technologies over fiber optic in the President’s plan to push broadband service into rural areas. Although that article discusses the means of carrying out the President’s plan, this paper is about justification for carrying out the project in the first place. In terms of economic freedom, the question becomes whether it is economically beneficial for the government to back such projects instead of leaving them to the private sector.

THE CIRCUMSTANCES

Currently, somewhere between 5 and 10 percent of Americans do not have access to internet at broadband speeds. This is according to a report put together by the National Telecommunications and Information Administration. The people affected are mostly rural citizens living in remote parts of the country. Their homes and cities are large distances from any decent sized urban centers. There is usually a considerable distance between each home which increases installation costs. Also, there are fewer residents per a given coverage area with which to spread the costs, which increases the individual cost per person. President Obama has set a goal of funding the infrastructure needed to supply broadband internet to these outlying areas.

REASONING FOR THE PROGRAM

The White House feels that broadband access in rural areas will provide job opportunities in the way of call centers or software development. It sees the internet’s utility to existing businesses and farmers for improved interaction with suppliers and customers as well as a useful tool for small and home-based business. In addition, the benefits and opportunities to education and the medical field are stated goals. As the president said in a State of the Union speech, the initiative is “about connecting every part of America to the digital age (Brendan.)"

PRACTICAL ARGUMENTS AGAINST THE PROGRAM

The broadband project has many admirable intentions. However, it is important to determine whether those are appropriate governmental actions. Is this assistance essential for the ones who stand to gain from it and is it truly necessary.

The purpose of the President’s plan is not extending internet to rural areas; dial-up internet via phone line is already available. The planned infrastructure is to be an improvement over what is already available. This is a key distinction. The basic benefits that the internet provides are already currently available to those rural citizens, albeit at slower connection speeds. Essentially, the President’s plan is to bring faster internet service to those rural areas.

The new infrastructure would allow for “photos and video, and using video conferencing (Tarter.)” Those are hardly necessities which, if they were, might justify this program. Since they are not, it is hard to see why government involvement is required. The social benefit to those rural citizens is closer to an improvement in luxury than one in basic necessity.

It is not as though the rural citizens are cut-off from the world, either. They have access to telephone and cable or satellite television, both of which would keep them abreast and up to date on happenings the world over.

For those citizens who actually require the benefit of a broadband connection, an alternative already exists. Broadband internet via satellite, though expensive, exists as an option in practically any rural area. Therefore, for rural businesses and farmers who see a benefit to having broadband service, the extra expense of satellite broadband would simply a cost of doing business.

THE ECONOMIC ARGUMENT

Some of the goals of the president’s plan sound economically beneficial and likely they would be. However, would they have a net beneficial effect? In other words, would the costs outweigh the benefits?

As the Businessweek article points out, there are several options for a delivery method such as fiber-optic cables or wireless technologies. Who is to say what the best option is for each situation? There is the very real possibility that the technology they install may be obsolete within a short time of being installed. In the private sector, a cost benefit analysis would be done to determine whether the benefit will outlast the initial cost. This analysis would be driven by the fear of loss of capital. In a government program such as the broadband initiative, the potential loss of capital does not weigh so heavy in the analysis. Instead, potential loss or gain of constituency usually replaces that consideration.

In totally free markets, private companies would assess whether there was a market to be gained which would reward the expense of installing the infrastructure. If they saw that the project was economically feasible, they would not hesitate to make the investment. The fact that private firms have spurned the project should be a red flag telling us that the project is not economically feasible.

According to the study done by the white house, the plan is intended to close a gap of only 14% between urban and rural broadband users. The study showed that about 70 percent of rural households were connected to the internet compared to about 84 percent of urban households. This relatively small gap (which is reasonably understandable considering the circumstances) does not seem significant enough to warrant the expense. The indication is that the broadband initiative will be a terribly inefficient allocation of resources.

Another consideration of this government program is that it will take opportunities away from those who may have found ways to work within the current infrastructure. For instance, those small businesses that currently provide dial-up internet service will be pushed out of business, not by natural competition, but by the government. What is more, the broadband campaign will discourage entrepreneurship and innovation. Left unhindered, entrepreneurs and innovators might have discovered new and better ways of reaching remote locations with broadband service and their discoveries could be the technological fuel for a new wave of advancements.

POLITICALLY MOTIVATED ISSUES

Implementing the initiative will require several choices to be made such as which areas to extend service to, which technologies get implemented, which firms are hired to install the infrastructure, as well as which firms are awarded the contracts for broadband service billing after the infrastructure is put in place. When the government and its officials are tasked with making these decisions, can we be assured that their choices are not politically motivated?

As shown earlier, the plan intends to close a relatively small gap of usage between urban and rural users of only about 14%. The reality that just a slight increase in usage would be realized indicates that the beneficiary pool from this project is a small number of citizens. Is it possible that those who will be benefitting the most are well-connected individuals who stand to benefit personally, and possibly monetarily, when broadband is extended to areas they have an interest in?

The technological options like wireless or fiber optic were mentioned earlier. The government has to decide which to implement. This decision will benefit the related industry. If fiber optic cable is chosen, the manufacturers of that cable will benefit financially. In that hypothetical situation, can the taxpayers be assured that lobbyist for that industry has not influenced the direction of the program?

Cable, internet and/or telephone service suppliers who will provide broadband billing services will gain new subscribers without the outlay of expensive investments in infrastructure which would normally be required. Regardless of how fairly the process of choosing who gets those contracts is, is it fair and equitable at all? For the government to take on the expense and risk of private enterprise while private enterprise accepts only the rewards is completely inequitable.

CONCLUSION

The plan to extend broadband is expressed in terms that appeal to the sensibilities of many of us. The marketing of it as “Strengthening Rural Infrastructure” sounds like a goal we could all get behind and be excited about. However, it is important to look below the surface and see what underlies the program. Since government programs use taxpayer dollars, it is necessary to ensure that the use of those funds is for practical purposes. Along those same lines, it becomes prudent to see to it that taxpayer money is not wasted on economically inefficient endeavors. Finally, confronting any possible political motivations is simply being responsible. In applying these criteria to the rural broadband initiative, the program does not pass the first two and is suspect in the last. It stands to reason that such a program is not appropriate in a free market society that believes in economic freedom.

Works Cited

Brendan, Greeley. "The Flaw in Obama's Wireless Plan - BusinessWeek." BusinessWeek - Business News, Stock Market & Financial Advice. Businessweek, n.d. Web. 24 Feb. 2011.

"Strengthening the Rural Economy - Strengthening Rural Infrastructure | The White House." The White House. N.p., 26 Apr. 2010. Web. 25 Feb. 2011.

Tarter, Steve. "Broadband map shows 10 percent of us still lack high-speed access - Peoria, IL - pjstar.com." Home - Peoria, IL - pjstar.com. Journal Star, 21 Feb. 2011. Web. 24 Feb. 2011.

Economic Freedom and Government Bailouts

DATE: February 24, 2011

TO: redacted

FROM: Scott redacted

SUBJECT: Economic Freedom and Government Bailouts

SUMMARY

One aspect of economic freedom is the independence to succeed and/or fail. This suggests that government should not aid its citizens in succeeding or failing, nor should government prevent its citizens from succeeding or failing. The federal bailouts of the auto industry in 2008 provide an instance where the government stepped in to attempt to stop some companies from failing. In doing so, they might’ve also prevented others from succeeding. Fortunately for the one company who stuck to free-market principles; foresight, planning and fortune kept them from suffering the consequences of the government’s actions. A recent article in Businessweek details Ford's record sales just two years after declining the bailouts. Although they do not provide us with a perfect example of the consequences of government intrusion on the markets, the bailouts are an interesting case study.

A BRIEF HISTORY

In November of 2008, the big three American auto manufacturing companies went to Washington for hearings on the possible need for a government bail-out of the industry. Poor management combined with the ongoing world-wide economic crisis made the continued solvency of these companies questionable. Whether to stave off job losses, to prevent further perceived harm to the economy or a combination of both, the government intended to backstop these companies with government loans and stock purchases as part of a bailout if necessary. Ford walked away from the talks saying they would not be needing the government’s assistance. The other two companies, GM and Chrysler, hung back and eventually accepted billions in government loans. Within months, both companies were dismantled in unprecedented government-backed bankruptcy proceedings.

THE OUTCOME

Ford should have failed and probably would have failed if it weren’t for a few fortunate circumstances. The government bailout obviously helped those who were given assistance, yet the consequence was that those who weren’t helped were in a less favorable position competitively. Not to mention, they likely lost any hard fought competitive ground gained over the years prior to the bailouts. Fortunately for Ford, however, consumers rewarded them for making what the consumers deemed as the right decision. Refusing bailout money gained enormous goodwill for Ford. Also helping Ford was the fact that, prior to the downturn, they had begun to refocus on making the company profitable. This also garnered consumer favor as this was seen as the appropriate action for the situation. At the same time, and in stark contrast, Chrysler and GM seemed to be in a state of atrophy. For many consumers, their inaction only served to highlight Ford as the only company worthy of their patronage.

Ford did not fail because they were better prepared to weather the economic downturn. Before the market decline, Ford’s CEO had already begun analyzing the company; seeking ways to improve and regain market share. They were beginning to implement changes designed to help the company compete in the small-car market and in Asia, two markets which the company suffered in. Ford’s willingness to cut their workforce, sell off property and focus on improvement in the face of an economic downturn also translated into consumer appreciation and new customers. Consumers who respected Ford’s bail-out decision and renewed profit-mindedness began to file into Ford’s showrooms. Ford’s sales rose and at the end of 2010, they posted their highest profit in over a decade.

General Motors, on the other hand, has taken to avoiding using the parent company name when advertising brands like Chevy and Buick. For Chrysler, this was their second trip to the government for a bailout having received a bailout under Lee Iacocca in the early eighties. They likely held no shame. As might be expected, sales at both companies are up for the year, as well.

CONCLUSION

It is good that Ford did not accept the bailout. Had they done so, then it could have been argued that the bailouts were not market interference. Proponents could claim that equal treatment was received by the entire industry, (forgetting that other industries in the economy shouldn’t be excluded from such an argument) and therefore it wasn’t really doing any harm, only good. But because Ford accepted the bailouts, we now have two examples from which to observe. We can watch the effects on the bailed out companies in contrast to the one that wasn’t bailed out and draw evident conclusions. The present may not be the best time to make any noteworthy inferences, but over the period of perhaps a decade, it should be possible to look back and see the effects of the bailout more clearly.

"Joel Ewanick On The Parent Company | The Truth About Cars." New Car Reviews, Ratings & Pricing, Auto News for New Models. N.p., n.d. Web. 10 Feb. 2011.

Priddle, Alisa. "Despite strong year, profit-sharing, Ford stock tumbles." detnews.com. The Detroit News, 28 Jan. 2011. Web. 9 Jan. 2011.

"The Happiest Man in Detroit - BusinessWeek." BusinessWeek - Business News, Stock Market & Financial Advice. N.p., n.d. Web. 10 Feb. 2011.

Valdes-Dapena, Peter. "AutoNation: GM, Ford, Chrysler driving up sales - Feb. 3, 2011." Business, financial, personal finance news - CNNMoney.com. CNN Money, 3 Feb. 2011. Web. 9 Feb. 2011.

"theblogprof: Take your bailout and shove it! Ford has its best year since 1999; profit-sharing checks to average $5K." theblogprof. N.p., n.d. Web. 10 Feb. 2011.

Lift Off

This first post is intended to be an outline. With Upward Down Flight, I plan to give personal reflections on or reactions to current events. This post will be handy to look back on to see just how far off course I've gone.

To start the blog, I will post several recent papers written for an undergraduate course in economics entitled "Issues in Economic Freedom." The instructions for the assignments were to find current news articles and discuss the economic freedom issue related to them. These will be presented pretty much the same as they were written: in memorandum format, with the intended audience being the professor for the course, and with works cited included.

As an Economics major, I would like to remain on that theme in this blog. There are many interesting concepts within the discipline which I would like to explore. I would like to avoid political issues where possible, however politics is inseparably intertwined with economics on many fronts. For the most part, I intend to remain as party neutral as I can. If views I express happen to coincide with those of any particular party, it will be coincidental to the supporting evidence and arguments. I may feel the need to go off topic occasionally and perhaps with this sentence I am giving myself permission.

This first bold step has taken a lot of courage on my part. Opening up a bit of my personal self to the world is somewhat against my nature. At the same time, assuming others find this blog, the nature of some of my posts will be open to a lot of criticism. There will be those who will certainly disagree with what I have to say. Argument is something I often tend to avoid by just "getting along," which is why I say it will take a bit of courage on my part to actually say what I think and face the opposing views and criticisms.

Along those lines, there is the need to have the conviction to stand behind what you write. I think it will be important to believe in what I've written before it is posted. But beliefs and ideologies tend to ebb and flow throughout a person's lifetime. Therefore, there is every likelihood that I will contradict myself at some point. C'est la vie.

Finally, to start something like this, one should have the conviction to keep it going. That will prove the most difficult. Finding the thoughts to write about is usually not nearly so difficult as finding the time to put those thoughts into a coherent and hopefully intelligent message. We'll just have to see how that goes.

Scott