A Bailout's Opportunity Cost

With all due respect to my Foolish colleague Seth Jayson, he keeps being far too kind in describing the bailout plans being bantered about in Washington and among the big banks. Let me take the kid gloves off and tell it like it is.

This -- or any -- bailout will be absolutely disastrous for any Americans who bothered to play by the rules. Here are just a few reasons why.

No. 1: Lost opportunity cost
If you actually saved a down payment and limited yourself to a house you could afford on a traditional mortgage, these bailouts are a direct slap in the face to you. After all, you could have "kept your powder dry" by investing the cash instead of putting it toward your down payment. And you could have taken out a mortgage with a lower starting rate that would have likely adjusted upward. Instead, you did the prudent thing by locking in a great long-term rate thanks to your strong down payment and staying within a mortgage you legitimately qualified for.

Had you known there'd be a bailout locking in your lower rates for five extra years, you might have made a different decision. On a $200,000 home, a 20% down payment is $40,000. Invested for eight years (three-year teaser plus a five-year bailout), that money could have legitimately grown to more than $85,000. And even if you would have financed more by not making a down payment, the lower interest rate from the now-extended "teaser" period would have largely offset the extra financing costs.

That's real money you could have had if you had known your teaser rate would be extended. Did you play by the rules? Sorry -- you're out of luck.

No. 2: Who will loan money in the future?
The theory behind these bailouts is that by slowing down the default and foreclosure rate, they'll help prop up the softening housing market. There's only one gigantic problem with that theory: The people who fronted the cash to make the now-defaulting loans did so expecting that they'd get paid back. What's more, they offered the teaser rates precisely because they'd get the extra interest once the teasers expired.

If those teaser contracts can be rewritten at will in a bailout, it sends a really nasty message to anyone who has money to loan in the future. With a message like that, who exactly is going to want to loan money at anything other than a punitive interest rate?

You think the housing meltdown is bad now? Just wait until the funding dries up even further because those with money to lend refuse to lend it in an environment where the contracts don't count.

No. 3: Who really wins?
In reality, many of the subprime loans that started this meltdown went bad long before their teaser rates expired. That's part of what so quickly killed so many subprime mortgage brokers this summer. Many of the loans they originated were forced back to them thanks to missed payments within a short window (often 90 to 180 days) after origination -- well before the teasers expired. And as largely pass-through entities, they certainly didn't keep enough cash on hand to handle the mounting defaults.

My opinion: The real winners from the bailout are the banks and financial institutions that have been taking writedowns for the defaulted subprime mortgages they carry on their books. Any temporary slowdown in new defaults will let them more easily unload their already-foreclosed properties. This will help them both pare their losses and potentially gain off mortgage debt they held and had previously written down as worth far less.

To give you a sense of how much is at stake, here are some of the recent writedowns:

Company

Writedown

Merrill Lynch (NYSE:MER)

$7.9 billion

Citigroup (NYSE:C)

$2.2 billion already;
$8 billion to $11 billion coming soon

Wells Fargo (NYSE:WFC)

$1.4 billion

Bank of America (NYSE:BAC)

$3 billion

Morgan Stanley (NYSE:MS)

$3.7 billion

UBS (NYSE:UBS)

$3.4 billion

JPMorgan Chase (NYSE:JPM)

$1.3 billion already;
expected to be larger next quarter

Sources: CNNMoney, MSN Money, Bloomberg, and Reuters.

These institutions -- and others like them -- aren't pushing for the bailout for any altruistic purposes or to help people in distress. I believe they're doing it simply to give them some breathing room to unload their already-foreclosed properties at still-inflated prices. It has little to do with helping real people in distress.

Too bad it will come on the backs of those of us who played by the rules and will now be asked to foot the gigantic, not-very-well-hidden bill. It seems that we are rewarding the guilty and punishing the innocent.

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