Dissecting McCain's Bailout Plan

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Back in March, Sen. John McCain stated that he has "always been committed to the principle that it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers."

Apparently, he was "against it before he was for it"
It should come as no surprise, then, that McCain's latest economic proposal is drawing a few blank stares.

During last Tuesday's presidential debate, Sen. McCain unveiled his new strategy: "I would order the Secretary of the 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 be able to make those payments and stay in their homes."

That's right: The Treasury would buy soured home loans from banks at face value, reset the amount the homeowner owes based on the property's current value, and have taxpayers pick up the difference. Unlike the $700 billion bailout, there would be no potential upside for taxpayers to recoup their losses -- they'd eat the difference between the face value of the loan and the renegotiated loan, end of story.

Would the proposal work? Eh, sort of. Yes, the plan would help homeowners, but it'd come with enormous downside risks that could do more harm than good. Here's my take.

The pros
McCain's plan has two benefits the current bailouts lack. It would:

  • Help recapitalize banks so they can start lending again.
  • Prevent homeowners who are "underwater" from walking away from their homes.

The first part, recapitalizing banks, doesn't get talked about enough these days. The $700 billion bailout is designed to prevent banks like Goldman Sachs (NYSE: GS  ) and Bank of America (NYSE: BAC  ) from going under, but it doesn't address what happens after they're saved. Without recapitalization, the banks won't be able to resume lending, because they still have to raise capital after the Treasury buys mortgage-backed securities at steep discounts. Under McCain's plan, you'd kill two birds with one stone: Banks could jettison toxic mortgage assets and get paid face value for those loans, giving them ammunition to start lending again.

The second part, preventing homeowners from "walking away," would be a boon for the home market. When the value of someone's mortgage is worth more than their home, they have an incentive to walk away, leaving the remnants of the home for the bank to deal with, even if they can afford the monthly payments. Get rid of that aspect alone, and you'd put an end to a swarm of bank repossessions and fire-sale auctions that are sending home prices into oblivion.

The cons
Boy, where do I start? I guess we begin with one obvious fact: The plan rewards those who took on the risk -- banks that made loans, and homeowners that bit off more than they could chew -- at the entire expense of taxpayers. Unlike the $700 billion plan, which demands equity stakes (like AIG (NYSE: AIG  ) , Fannie Mae (NYSE: FNM  ) , and Freddie Mac (NYSE: FRE  ) had to forfeit) and only buys securities at a steep discount to face value, McCain's proposal comes about as close to a get-out-of-jail-free card as it gets.

Buying back rotten mortgages at face value is the epitome of bailout opponents' favorite phrase, "moral hazard." If you pay back banks for their mistakes at face value without any compensation, what incentive do they have not to go out and do it all over again?

Beyond mere moral hazard, the plan could instigate downright fraud. If homeowners can afford their mortgage payments, but know that if they start to default, Uncle Sam will swoop in with a blank check, any rational homeowners might pretend they can't afford their homes, just to grab a free handout.

And what about that $300 billion figure McCain proposes -- would it be enough? When JPMorgan Chase (NYSE: JPM  ) failed out Washington Mutual, it said it planned on lopping off $31 billion in bad loans. When Citigroup originally offered to buy Wachovia (NYSE: WB  ) , it said it could only absorb the first $42 billion in losses. Just from those two banks, you're looking at potentially $70 billion in soured loans. It seems a bit optimistic to assume $300 billion will clean up the entire market.

And think about this: 12 million homeowners owe more on their mortgages than their homes are worth. $300 billion comes out to around $25,000 per underwater homeowner -- obviously, not nearly enough to reset every sickened home loan. Plus, if real estate were to fall much further after the mortgages were renegotiated (which it probably will), those homeowners would be back under water, and we'd be back to square one, pulling our hair out.

Alas, no one said it was easy being a maverick.

Fool, baby, Fool:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Fool's disclosure policy delivers nothing but straight talk.

Read/Post Comments (4) | Recommend This Article (11)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 13, 2008, at 3:43 PM, mlaursen wrote:

    And if you're someone who is trying to break into home ownership, you don't want the government running in and propping up the high prices of housing.

  • Report this Comment On October 13, 2008, at 4:20 PM, Miami72 wrote:

    Wait a minute now!

    I have a home that is underwater $90K, value wise. But the 1st / 2nd loans were set at 80% LTV when I took them out and they are both fixed rate (i.e. Non Toxic). My credit score is in the 760's and I have been diligently paying the mortgages. I still feel victimized by the market – Wall Street actually, I always said they were manipulating the rest of us. I would love to get out from under these loans and have them reset at the current value of the home. But it seems like the “Good Guys” get it in the end again!

  • Report this Comment On October 14, 2008, at 2:21 PM, chali2na wrote:

    Is there anyway to invest in education? That seems to be the reason these things are one knows what they're doing....not even these candidates really know what is going on....they just read what they're told to say, which is what everyone wants to hear so they get their vote. The markets really should be allowed to take care of'f funny how adults say that kids these days are spoiled. Seems to me the adults are just as spoiled as they are constantly bailed out before they learn the hard lessons in life. I am grateful that my parents and grandparents learned the lessons of the past and passed that knowledge on to me so I have the ability to think for myself and make responsible decisions. Ron Paul 2012.

  • Report this Comment On October 14, 2008, at 10:38 PM, tradeview wrote:

    "I would order the Secretary of the 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 be able to make those payments and stay in their homes."

    Key part of this statement which is being totally overlooked:

    " the diminished values of those homes.."

    Can you spell D I S C O U N T ?

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