Bailout Dilemma

It’s no secret that we are currently in a recession. The government is exploring various approaches in trying to get the economy on the right track as quickly as possible. Which industries should be bailed out? Which companies should be offered financial help? How much aid is too much? Should homeowners be bailed out directly? Which homeowners should be bailed out? How much help should be given? The questions go on and on and we can only guess what the right answers are. It’s only in looking back years from now will we be able to judge the success or failure of today’s decisions.

We live in a society that has grown accustomed to instant gratification. We expect instant results whenever we do something. We expect our associates to answer their cell phones on the first ring; e-mails need to be answered within minutes of hitting the send button. Shipping of anything is expected to be done overnight and we are annoyed when our computers take more than 30 seconds to boot up.

With this level of expectation we expect the government to turn the economy around overnight and we are disappointed when a program is implemented and we don’t see positive results within a matter of days. It’s important to recognize that there is nothing that can be done that will make this a short recession. We will be in a much stronger position to deal with this economy if we recognize that fact.

In my article, “Today’s Financial Paradigm Shift” I pointed out that we, as a society, need to change the way we handle our finances. Society’s resistance to this change is only going to make matters worse and this recession longer. Let me list a few examples.

It’s fair to say that the average American doesn’t save enough. Statistics show that our nation’s saving rate has been 1 to 2% on average over the last several years with it drifting into negative territory at some points. Statistics also show that the average American lives day to day off their credit cards not even paycheck to paycheck but day to day. It’s generally assumed that we would all be better off financially if we increased our rate of savings.

We’re told that one of the reasons the economy is in the state it’s in is that we are living above our means. This applies not only to individuals but companies and the government. We can conclude that for us to have a vibrant economy we need to curtail spending and increase our savings. By being less credit dependant we’ll all be better off.

What approach has the government used to stimulate the economy? Last year they gave every American a rebate check and encouraged them to go out and spend it. This didn’t have any long-term impact so now they are considering doing it again.

The price of gasoline has dropped substantially over the last few months. The economy still isn’t getting stimulated because Americans are paying down their debts instead of spending the money. This is perceived as a negative because it’s not turning the economy around in the short term. It fact it is making for a stronger economy in the long-term. This change in spending habits should be encouraged, not discouraged.

We are told that Washington bailed out Bear Stearns, Fannie Mae & Freddie Mac and the money could have been better spent somewhere else. There may have been better ways to spend the money but I have a problem with identifying these actions as a bailout. The owners of Bear Stearns, the stockholders, loss 90% of their investment in the company. The stockholders of Fannie and Freddie lost 100%. These stockholders are no better off than the stockholders Lehman Brothers, which was allowed to go into bankruptcy. The cash infusions into the major banks, insurance companies and possibly the auto manufacturers is enhancing shareholder value, making those investments bailouts.

Were these decisions the right decisions or the wrong decisions are open questions. We do need to avoid calling all these actions bailouts, since clearly not all of them are. We are again attempting to address the short-term economic problems with the same actions that got us into trouble in the first place. These companies were making investments outside their means getting them into the same financial hardships consumers got into when they spent above their means. Unfortunately we need to deal with painful short-term problems if we hope to attain a long-term cure.

The latest focus of Washington is to address the high rate of foreclosures throughout the country at the homeowner level. A foreclosure not only hurts the homeowner and his lender but the local community also. If the number of foreclosures is reduced there will be an economic boost at the local level that will permeate though the entire economy.

This approach also has a “feel good” component to it. We, as a society, are helping out our neighbors that need it the most. Theoretically this seems like the perfect way for the government to invest in the greater good of the economy and it may turn out to be the most viable approach to the problem. It also can prove to be the most devastating if it is not handled very carefully.

There are 2 pitfalls that need to be avoided. The first one is finding the proper balance between helping out those that need help without encouraging other homeowners to put themselves in need. For example, if you decide to help out any homeowner that is currently 60 days behind in their mortgage payment you are also announcing to any homeowner that is 30 days late that they should miss the next payment. Whatever guideline that used, this problem will arise making this a difficult issue to address.

The second pitfall is even more difficult to deal with. The most common reason homes are falling into foreclosure in many parts of the country is that the current value of the home is less than the outstanding mortgage balance. This situation can occur for several reasons. The cause that put the homeowner underwater must be considered in determining if a mortgage should be modified or else we will be assisting borrowers that don’t deserve to be helped.

A homeowner could have been scammed into purchasing an over priced house due to a fraudulent transaction. Obviously this is a situation where the mortgage should be modified.

The real estate market could have dropped substantially since the homeowner closed on his house. Should his mortgage be modified if the mortgage balance is in excess of the resale value of the home? What about his neighbor, who made a substantial down payment when he bought his house, should something be done to help him? Is it fair to help out the first borrower who didn’t invest as much of his own capital in the purchase and ignore the neighbor who decided to do the prudent thing and carry a smaller mortgage?

What about the homeowner who bought his house 5 years ago, refinance it last year taking as much equity out of the house as possible who is now underwater with his mortgage? Should this mortgage be modified? Should it make a difference if he took the money and invested in upgrades to the house, paid off other bills with it or just took a vacation?

The banks will have to be selective in deciding which mortgages to modify. The effect of this selection process will be (1) homeowners who genuinely need to be helped getting help, (2) homeowners who shouldn’t be helped getting help and (3) homeowners who were conservative, did what they thought was the prudent thing to do and are just hanging on watching from the sidelines.

The animosity this will cause between neighbors needs to be considered when addressing foreclosures on the local level.

In attempting to turn this economy around in the shortest period of time and with the least amount of pain we run the risk of encouraging people to continue with their bad spending habits. We need to take advantage of this recession by encouraging people to live within their means and save for their futures. By taking the pain of this recession and turning it into an opportunity we will all benefit. We just need a little patience.