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Why direct mortgage subsidy is a bad idea

In my continuing series (okay, well, two posts make a series I guess) about the economy, I want to address why the populist approach won't work.

A friend pointed me the other day to a Guardian article which was full of the usual ignorant mish-mash of "solutions to help Main Street, not Wall Street" and included this:

At the same time, several steps can be taken to reduce foreclosures. First, housing can be made more affordable for poor and middle-income Americans by converting the mortgage deduction into a cashable tax credit.

The Guardian article is the only place I've seen this idea explicitly, seriously suggested, but I have seen a similar sentiment ("The government should be helping out Main Street, not Wall Street!" "The real victims here are those who took out subprime mortgages? What's in it for them? Why aren't we helping them out directly?") in very many places. But actually, the idea of "giving money directly to Main Street, and letting Wall Street hang" is precisely counterproductive to this goal.

So, let's think about this for a minute. Pretend that, suddenly, the US passes legislation to allow mortgage interest to be a tax credit. What this means is that you can tell the US government that you spent $X on mortgage interest in 2008, and they will subtract $X from your tax bill. If this makes your tax bill negative, the government will send you a check for $X - (your tax bill). It is basically saying, "the US government will pay your mortgage interest."

This sounds great, doesn't it? If you're a US citizen with a mortgage, anyway. But let's think about it for a minute. The interest on a loan is the money that the bank who owns the loan is making, as recompense for your having taken their money to buy something for yourself. Generally, when you have first bought a house, the mortgage interest comprises the majority of your payment. (Play with a mortgage amortization calculator if you don't know what I mean.) So the Guardian writer is proposing, basically, that the government should pay the bit of people's mortgages that makes up the vast majority of the monthly payment right now. It also means that the government should pay, over the life of the loan, the part that is the payment to the lender for having made the loan. And so:

  1. This will make it a lot easier for people to pay the mortgage, at least in the first few years.
  2. This means that most of the mortgages that have been sliced & diced into CDOs will be good.
  3. This means that the banks who bought CDOs will receive the profit, that is the mortgage interest, courtesy of the US government.
  4. This means that the "toxic debt" won't be toxic anymore.
  5. This means that the CDOs will have precisely the inflated value that the banks assumed all along that they would have.
  6. This means that the US government will directly be paying interest money to the banks who hold the debt, that is, the investment banks who bought the CDOs.
  7. This means that the "bad, stupid" CDOs that the investment banks bought won't be so stupid after all—they'll be guaranteed by the full faith and credit of the United States government! There will be a party on Wall Street again after all!

It's a great way to get the money straight to Wall Street, with some incidental benefit to Main Street. But wait, I thought we were supposed to be bailing out Main Street and not Wall Street? Oops.

The best feature about the Paulson plan is that it pays a fair price (including the pessimism about Main Street being able to pay their mortgages) for these CDOs, and since it's a fair price, they will be able to sell these CDOs for at least the price paid, in future. The taxpayer will not, in the end, lose money if this plan is executed properly. (Yes I know, that's a big "if", but at least it's not a dead certainty that we'll lose money.) The plan has the side benefit, which Congress seems to have noticed, that the US government would hold a lot of slices of a lot of mortgages, and it would suddenly become possible (as it isn't at the moment) to put these mortgages back together and re-negotiate the terms with homeowners on the edge, and try to keep them in their houses. But the main benefit is that Paulson has come up with a way to put a bunch of taxpayer money on the line to keep the economy functioning, and get the money back in the end, so that the taxpayer won't be out of pocket in the end. This is the part that I love. How many government employees do we have who can still think of ways to retain the taxpayer's money in such an impressive way?


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Comments (4)


You're the financial wizard here, but it seems to me you left out a couple of key points:

1) If you only pay the interest of people who are currently in houses, not those who may subsequently wish to, it's a weird and arbitrary line.

2) But if you pay interest in future, you're a) incentivizing people to buy dramatically more expensive houses than they otherwise would have (sound familiar?), b) driving up house prices a lot, c) putting future people into exactly the teaser-rate-ARM problem, where their houses are initially affordable but become less so with time, only now you're doing it as a matter of national policy, and d) telling people that interest-only mortgages are a wise course of action (read also: (temporarily) free house!).

3) Also, the important aspect of the Wall-Street-not-Main-Street thing for me is that I don't think this is a mortgage crisis. It may have started as or been triggered by mortgage issues, but it seems to be a credit crisis. People can't pay (or get) mortgages, but they also can't get student loans, small business loans, large business loans, etc. You can pay off people's mortgages all you like but they are not then going to turn around and become lenders, and it will not be helpful long-term, for anyone, if most of the lenders have collapsed.

I think a Wall-Street-*only* plan would be bad for both moral and political reasons, and the US government has done an inadequate job of defending its plan on those grounds, but a Main Street only plan would be worse.


All good points. I didn't say this clearly enough in my post, but I wanted to point out how "helping Main Street" in the proposed way is actually a direct line to "helping Wall Street", and has precisely the opposite result that its proponents seem to intend. Your points about the perverse incentives that would result for homeowners is extra icing on the cake—not only would an interest-only mortgage be a free house for the homeowner, it would be free money for the banks that made the loan. And when you get to the end of the 30 years? Refinance!


Personally, I don't see anything wrong with helping Wall Street via helping Main Street -- I think people who view the two as necessarily in opposition are missing something crucial about economies. The argument I heard for doing something about the mortgages directly was that it would be a way of helping Wall Street by giving its assets real, substantial market value, rather than having the government guess and pay that. My understanding is that this was then supposed to positively affect the credit situation, as having nonzero values for the assets on the books should help banks approximately as much as no longer having weird assets on the books.

Which is of course not to say that the other objections aren't good ones. The weirdness of providing arbitrary help to homeowners, but not would-be homeowners, is an interesting puzzle; the last thing we need is more crappy incentives.


The argument of "helping Wall Street via Main Street" is one I hadn't actually heard yet, and it does seem to display more clue about how economics works. I still think it would not be the optimal solution (even leaving aside the bad incentives it sets up) because the US government would be paying the maximum retail price to keep these assets up, rather than their probable market value at the moment.

It's important to remember that these assets do have real, substantial market value—not everyone is going to default on their loans, after all. I'd rather have the taxpayer pay the market value, and reap the eventual reward (particularly if, at the same time, the government takes action to help struggling homeowners and thus improve the market value of these assets) than to have the government effectively inflate the real value of the debt by guaranteeing the interest.

And, of course, although I have hardly mentioned them, and although you and Andromeda have both said this, it is worth just saying again that the incentives set up by a tax write-off for interest really are appallingly bad.

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Posted on October 3, 2008 12:59 AM.

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