Friday, March 28, 2008

Instead of just blaming the victims for the mortgage crisis, how about also looking at tax policy?

In regard to the mortgage crisis, it's easy to point fingers at "irresponsible" home buyers. Just ask John McCain. However, our vast nationwide credit binge was decades in the making and involved a lot more than reckless home buyers. The mortgage crisis has many causes and was fueled by all segments of the financial industry and its regulators. In what seems like a classic example of the law of unintended consequences, at least a part of it also involved tax policy.

More than 20 years ago, Congress took steps to end the tax deductibility of consumer interest. The Tax Reform Act of 1986 phased out the deduction, ending it entirely in 1991. While it was a revenue enhancer for the feds, you could also make a case that it was good social policy. The U.S. already had one of the lowest savings rates in the world. The least the government could do, went the thinking, was stop subsidizing borrowing.

The trouble was, Congress left a huge loophole, one that spawned a whole new industry, a loophole that helped facilitate the country's incredible credit binge of the last two decades. Residential mortgage interest retained its deductibility, and home equity mortgage lending took off, as homeowners rolled more and more consumer credit -- especially car loans -- into home equity loans.

There were skeptics at the time who said it didn't make much sense to pledge your home against depreciating assets like cars or other consumer ephemera. Others pointed out that encouraging the conversion of home equity into debt threatened the last form of saving practiced by many Americans. But buoyed first by inflationary increases in home prices and later by easy credit, the market boomed. It was a nearly universal "win-win" -- lenders made money, sellers made money, buyers repeatedly "cashed out" their equity gains. Financial perpetual motion seemed to have been invented, and few noticed its resemblance to a national Ponzi scheme. After all, houses always increase in value, don't they?

Now the chickens are coming home to roost, flocks and flocks of them. Americans now owe an incredible $1.1 trillion on home equity loans according to the NYT, which notes that banks worry they may not get all of that money back. It turns out that the loans have a double impact on the mortgage crisis, because: 1) Many of the loans are themselves going bad, and 2) Home equity loans make it more difficult to deal with an underlying troubled mortgage, either by renegotiating or selling.
It is a remarkable turnabout for the many Americans who have come to regard a home as an A.T.M. with three bedrooms and 1.5 baths. When times were good, they borrowed against their homes to pay for all sorts of things, from new cars to college educations to a home theater.

Lenders also encouraged many aspiring homeowners to take out not one but two mortgages simultaneously — ordinary ones plus “piggyback” loans — to avoid putting any cash down.

The result is a nation that only half-owns its homes. While homeownership climbed to record heights in recent years, home equity — the value of the properties minus the mortgages against them — has fallen below 50 percent for the first time, according to the Federal Reserve.
This is going to get really ugly before it gets better.
In places like California, Nevada, Arizona and Florida, where home prices have fallen significantly, second-lien holders can be left with little or nothing once first mortgages are paid.

In December, 5.7 percent of home equity lines of credit were delinquent or in default, up from 4.5 percent in 2006, according to Moody’s Economy.com.

Lenders and investors who hold home equity loans are not giving up easily, however. Instead, they are opposing short sales. And some banks holding second liens are also opposing refinancings for first mortgages, a little-used power they have under the law, in an effort to force borrowers to pay down their loans.
None of the major proposals to help homeowners wtih delinquent mortgages really addresses the problem of home equity loans. With the economy sagging into recession, those delinquency rates are going to keep rising. Probably not what Congress had in mind in 1986, but it's where we are now.

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