McCain's New Plan

I'm not an economist, so maybe I just don't understand its true brilliance, but the new McCain plan for buying up mortgages doesn't seem to make much sense to me. Here's what CNN says:

Under a mortgage rescue plan announced at the debate Tuesday night by Senator John McCain, much of the burden of paying to keep troubled borrowers in their homes will shift to taxpayers.

McCain's original plan called for lenders to write down the value of these mortgages, and take those losses. McCain unveiled the new $300 billion plan in response to the first question of the debate.

He said, "I would order the Secretary of Treasury to immediately buy up the bad home loan mortgages in America and renegotiate at the new value of those homes, at the diminished values of those homes, and let people make those - be able to make those payments and stay in their homes."

The government would convert failing mortgages into low-interest, FHA-insured loans.

So the government would be buying up troubled mortgages at full face value with the taxpayers covering the difference between the loan amount and the new home value. That makes no sense to me. Under the bailout plan as currently contemplated, the Treasury would be buying up mortgage-backed securities at far less than face value and forcing financial institutions to take losses. And they should be taking losses. They made bad bets. Why should they get full face value for these loans?

Moreover, this approach creates a horrible line-drawing problem. Nearly all Americans who own homes have suffered as a result of the bursting of the housing bubble, not just the ones who are currently delinquent on payments. Equity they thought they had has vanished. Their homes are worth much less than they were two years ago. What this plan does is it takes this loss of equity and transfers it to the taxpayers--but only for certain homeowners.

Who would qualify? According to McCain's chief policy advisor:

To qualify, homeowners would have to be delinquent in their payments already, or be likely to fall behind in the near future. They would have to live in the home in question - no investment properties would be eligible - and have had demonstrated their credit-worthiness when they purchased the property by putting down a substantial down payment and by providing documentation of their income and assets - no liar loans.

First, I don't know how the Treasury is supposed to determine which homeowners are "likely to fall behind in the near future." And however you draw that line, those on one side of it are going to receive a massive windfall while those on the other receive nothing. And that's problematic both politically and morally given that the homeowners who acted the most responsibly are much more likely to get the short end of that deal.

And on the other end, if you exclude those people who did not "demonstrate their credit-worthiness" prior to purchase, you are excluding a large percentage of the problematic mortgages that are at the heart of our current problems.

Much of the current financial crisis stems from leveraged bets that were made on the very worst mortgages. If you leave them out of your solution, you're not really dealing with the problem.

I sympathize with the desire to go to the root of the problem and help actual homeowners (as opposed to financial institutions), but this doesn't seem like a good way to do it. It's too uneven a solution and it rewards financial institutions at taxpayer expense. Refinancing programs, like the ones that have already been passed, are good ideas, but it becomes problematic when the government steps in and reduces the amount of principal owed (especially when the banks don't have to take the hit). I think bankruptcy judges should have the authority to reduce principal owed, but that's very different. No one wants to declare bankruptcy. It's a last resort, so there's little risk of manifest unfairness or moral hazard.

But if the government just starts buying up people's mortgages and reducing the amount of principal they owe, you run into massive administrative and fairness problems. It just strikes me as a really bad idea.

UPDATE: Okay, the economists are backing me up. Both Krugman and Delong say this is bad idea.