Why the Feds Rescue Banks, Not Homeowners

The financial bailout is on, and so far the government has injected upwards of $150 billion in a variety of banks, not to mention a $120 billion loan for insurance giant AIG and $25 billion for the Detroit automakers.

As for helping distressed homeowners, Washington is still thinking it over.

On the surface, this might seem like the outrage of the century. The huge commitment of $700 billion in taxpayer money is supposed to help taxpayers, after all, and it's hard for many people to understand how adding a bunch of bank stock or insurance-company IOUs to the government's portfolio does that, exactly.

Giving individual homeowners a helping hand is a simpler concept, especially when the government just sent many Americans a $600 or $1,200 stimulus check a few months ago. So why not help lower mortgage payments, too? John McCain has even suggested using $300 billion of the bailout fund to aid borrowers on the brink of losing their homes.

But the regulators and bankers who would have to enact such a plan don't want to touch it. And they're not as foolish as populist politicians often portray them. Here's why a homeowner bailout plan is the hottest hot potato in Washington:

Voluntary programs don't work. There are already several voluntary efforts to encourage banks and their customers to renegotiate failing mortgages on their own, such as the HOPE NOW program that regulators cite frequently as a stand-in for a real solution. But voluntary efforts are marginal at best. First of all, most banks are free to rework loans without any government urging at all. The reason they don't—big surprise—is that they often lose money. Even if the government tries to strong-arm the banks, that doesn't eliminate the loss, and CEOs still have shareholder money to safeguard. Telling stockholders that "the government said so" doesn't usually justify poor financial performance.

By the most optimistic assessment, the banking industry is reworking about 200,000 troubled mortgages a month, without government compulsion. That might sound like a lot, except there are about 5 million mortgages in foreclosure or at risk of default. So 200,000 workouts amounts to resolving 4 percent of the problem each month, assuming there are no additional foreclosures. But the economy is getting worse, not better, and intensifying layoffs are going to lead to more problem mortgages, not fewer. In recent testimony before Congress, FDIC Chairman Sheila Bair said that "some of the voluntary efforts have helped, but it has clearly not helped enough. We are falling badly behind."

A homeowner bailout would have millions of moving parts. Bailing out banks requires a lot of money and a very careful strategy, but once the Treasury Department has determined which banks to help, the process is straightforward: The government buys preferred shares in the bank, according to standardized rules. Even if the government invests in 1,000 banks, the procedure should be the same in virtually every case.

It's extremely difficult to establish standardized rules for salvaging individual mortgages. Of the 5 million problem mortgages, the majority have been "securitized," which in many cases means the loan has been carved up into various pieces representing repayment of the principal, say, or the interest payments, and then bundled up with pieces of other mortgages and sold as securities to investors worldwide. Some of those have been resold to other investors or pledged as collateral in other deals. It could take as much work to identify all the investors in a single $300,000 mortgage as it does to execute a $3 billion federal investment in a bank with thousands of customers. Now, multiply that effort by 5 million loans. Wanna manage that program? Neither does Bair or Treasury Secretary Henry Paulson.

Homeowner bailouts could worsen the problem. Even when reworking a loan might help save a home and keep the payments coming, there still might be risks to the bank—especially if it's a local bank that issued a lot of mortgages in a concentrated area. "If you suddenly tell borrowers there's a lower amount due, others may see that and stop paying," says economist James Barth of the Milken Institute. So bailing out one guy might persuade his neighbor to stop making payments, even if he can still afford to, and hope for a better deal instead. That makes banks reluctant to renegotiate in the first place, and when they do, they often ask for concessions that the borrowers reject.

One stipulation of a federal program, for example, is that in exchange for a loan guarantee, the government gets a big chunk of any future appreciation in the house, even if you don't sell for 25 years. But sharing your house with Uncle Sam is a strange proposition, and even distressed borrowers are reluctant to go along with that.

The worst loans are the hardest to track. If banks simply issued mortgages and then held onto them, as in the George Bailey days, the problem wouldn't be so complicated. In fact, the FDIC is already reworking at least 40,000 troubled mortgages at IndyMac, the big California bank it took over in July. When the loan is held by the bank that issued it, there are no downstream investors to consult, and the mortgage is usually still intact. At IndyMac, workout efforts are aggressive, because the FDIC doesn't have shareholders to answer to and it wants to fix the bank's balance sheet as fast as possible.

But the riskiest subprime loans—and especially adjustable-rate subprimes, the most "toxic" of all—aren't typically held by banks. Here's the math, according to recent analysis from the Milken Institute:

• About 50 percent of all foreclosures involve subprime mortgages.

• About 68 percent of all subprime mortgages are securitized.

• About half of all securitized subprime loans are held by private institutions, rather than government-controlled entities like Fannie Mae and Freddie Mac.

That means the majority of the bad loans bringing down the housing market are controlled by the private investors whose greed and carelessness fueled the problem in the first place. And there's nothing an individual borrower can do to control who holds his mortgage. The government could help borrowers by buying up all those bad loans, at enormous expense, then essentially refinancing on terms more favorable to the homeowners. But that would amount to an egregious bailout of some of the shadiest players in the business. Even if taxpayers could stomach that, the downstream investors all have different stakes in the mortgage-backed securities they hold, with no motivation to agree to a single bailout plan. And so far, nobody in Washington has figured out a palatable way to help borrowers without also bailing out the downstream investors holding the securities, at a price the government can afford. Anybody who can solve that conundrum should contact Paulson and Bair immediately.

It's hard to tell which homeowners deserve to be rescued. Most people agree that the government shouldn't bail out flippers who bought and sold homes to make a quick buck or people defaulting on a vacation retreat. In real life, we might know who those people are, but the banks—and the government—don't necessarily know. In some cases, it's easy to tell from loan documentation whether the property in question is a second home, or whether the borrower was unqualified for the loan in the first place. But remember, one part of the problem was "no doc" loans that didn't require very much disclosure. In other cases, lenders or borrowers simply lied, and nobody noticed or complained. A comprehensive bailout plan might catch some of those borrowers, but others would essentially be rewarded for their cunning and hubris.

Washington wants to punt. Just writing that big $700 billion check was exhausting enough. You expect Congress and the Bush administration to bail out homeowners, too? Hey, don't rush them. Treasury and the FDIC already have enough on their plates, and Congress is looking forward to a post-election recess, not another migraine. Once the election is over and the next president takes office, there will be more enthusiasm for helping the little guy. Especially if somebody can come up with a reasonable plan by then.