Why a Foreclosure Rescue Plan May not Work as Intended

by Alex Stenback on November 18, 2008

Deborah Solomon, writing over at the WSJ blog Real Time Economics, teases out an interesting angle on just why Treasury is reluctant to use Federal rescue funds to support a loan modification/foreclosure prevention plan in the manner being advanced by Sheila Bair at FDIC and congressional Democrats, where the government covers 50% of losses on modified loans that re-default:

Mr. Paulson and others have qualms with it, in part because they believe it provides an incentive for banks to foreclose and may convince some borrowers to stop making payments in order to qualify for government aid. Within Treasury there’s a view that if the government is going to cover half the loss, banks will modify the terms of a loan for weak borrowers they know can’t make their payments, then foreclose and get the government to make up half the loss.

See how that works?  By modifying only those loans highly likely to default again, a program intended to benefit homeowners and slow foreclosures might actually increase foreclosures, at least in the short term.

Worse yet, unlike buying shares or "troubled" assets from the banks, there's not even the veneer of government "investment." The egovernment is just paying directly for losses.

This is why bailouts get so sticky.  Once the money starts flowing, everyone involved alters their behavior to get the maximum financial benefit, with all sorts of predictably ugly results: Homeowners defaulting on purpose to get a modification, banks modifying doomed loans to halve their losses, that sort of thing. To the point where we've got multinational insurance companies buying up smallish savings and loans to hang a thrift charter around their neck and gain access to the Federal cookie jar.

{ 1 comment… read it below or add one }

Miranda November 19, 2008 at 6:37 am

Ah, the Law of Unintended Consequences. I, too, have been leery of the bailout for this reason. The government (hopefully) means well, but people and businesses will take advantage if they can. Plus, the setup further rewards risky financial behavior (missing payments, etc.), encouraging poor decisions.

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