Press Statement

STATEMENT: Bailouts and Bold Action

By David M. Abromowitz

Washington, D.C. – The Bush administration labels the$15 billion in the Neighborhood Stabilization Act of 2008 (HR 5818)—legislation to help stabilize hundreds of communities swamped by foreclosures across the country—as a bank "bailout." Advocates of the funding in Congress and around the nation argue that the $15 billion is essential to keep communities from falling into blight, and to help millions of additional American families from losing all equity in their homes and then facing foreclosure.

What is the correct view? The questions and answers below should help clarify the issue.

What is a bailout?

A bailout is the use of government money to save a party who took undue risk or engaged in unsavory practices from being hurt by the consequences of taking those risks and actions. Some observers viewed the effort to keep Detroit automaker Chrysler out of bankrputcy in the 1970s as a "bailout.” Others saw the refusal to extend credit to a flailing New York City in that same decade as a denial of a bailout.

More recently, public funding to aid the airline industry in the wake of the 9/11 attacks was acknowledged to be a type of bailout, but was justified given the unprecedented assault. Similarly, many believed that the Federal Reserve-orchestrated buyout of investment bank Bear Stearns Cos. by J.P. Morgan Chase & Co. earlier this year represented a perhaps justifiable bailout of lenders to the collapsing investment bank amid a global credit crisis. Often, the eye of the beholder is what really matters, but it is still important to use the term correctly.

When a house is foreclosed on, and later bought by a new homeowner, is anyone bailed out?

Generally, no. The original homeowners lose the home, so even if those borrowers made a bad decision or took a big borrowing risk, they lost. After foreclosure, the home is sold by the foreclosing lender. If government money were used to enable that lender to then resell the home for more than it loaned, or substantially more than the home is worth after foreclosure, then it is possible that the sale could be viewed as a "bailout.” That, however, is not what H.R. 5818 would do.

Market data shows that is also a false scenario. Lenders who were not even making subprime loans before the crisis hit currently say that on average they are recovering only 75 cents for every dollar lent on homes that go into foreclosure and are resold. Subprime lenders today are reportedly recovering on average roughly 50 cents on every dollar outstanding on their loans at the time of foreclosure. The sale prices of foreclosed properties run in the range of tens of thousands of dollars in most parts of the country, a dismal price for lenders that is exacerbated by the many subprime mortgages still falling into default and foreclosure in these same neighborhoods.

Is H.R. 5818 authorizing a bailout?

No. H.R. 5818 appropriates funding to enable community-based organizations and local governments to acquire foreclosed and vacant property at about the average current neighborhood value at the time of the purchase. Because of the targeting provisions, the funds only go to hardhit communities where home values have dropped enormously in the last year or two. Appraisals are required. Protections are built into the bill to use the funds efficiently.

If enacted, H.R. 5818 will allow some sales to begin in neighborhoods where there is little or no sales activity, but at prices steeply discounted from what the lenders now owning the properties originally lent.

Isn’t expending government funds for buying homes an unwarranted intervention in the market that can only distort prices?

The communities and neighborhoods that would be helped by HR 5818 funds are ones where the market is not functioning normally. Prices have plunged rapidly and unexpectedly. Supply has surged, while demand is at best steady and in many cases slackened. Many otherwise interested homeowners suddenly find the fear of further price drops in these neighborhoods to be a deterrent to making a purchase.

This in turn accelerates the huge abnormal spikes in foreclosures as existing homeowners cannot sell their properties yet face rapidly rising interest payments on their subprime loans. Such foreclosure “hot spot” inevitably affect otherwise stable housing nearby, and cause further foreclosures and abandonments—despite otherwise unchanged market and individual economic conditions. This effect is much closer to the pricing effect of an artificially induced glut in the market on the price of a commodity than any normal business or economic cycle. And, as many local officials have noted, after this happens the government is intervening in depressed neighborhoods—with firefighters, police, and other escalating costs of blight.

As a consequence, only some external stimulus on a large scale is capable of restoring a normal market. H.R. 5818 appropriates money to allow this to happen in many local markets. This money will help restart purchase activity in and of itself, and can in some communities send the "price signal" that enables the market to return to normal functioning, as otherwise skittish buyers see price data that prompts their action. In addition, these purchases by local governments and non-profit groups provide additional price information to housing appraisers.

Why shouldn’t lenders who made bad loans just have to sit and hold the properties until the market produces a buyer?

Eventually, buyers will come. In some communities today, so-called "vulture" buyers are already looking around, trying to buy homes cheaply, and they will eventually do so. But most such vulture buyers are absentee landlords who turn formerly stable homeownership communities into concentrations of poverty and lowerincome renters. These new owners generally have no incentive to invest in or even maintain properties so long as normal market functions are broken to the extent that they can’t refurbish their new properties and sell them for a profit.

The Upshot

There is no connection, therefore, between the price at which a lender will be able to sell a foreclosed home and the price level at which responsible low- and moderate-income home buyers will be able and willing to come back into the market. A community-based group or local government with neighborhood stabilization funding under H.R. 5818, however, can take the longer view and buy up such properties at a relatively cheap, affordably sustainable price. That process does not constitute a bailout. Instead, it represents bold action to help stabilize communities hit hardest for the subprime mortgage crisis.

READ THE FULL REPORT: http://americanprogress.org/issues/2008/05/bailouts.html