Are Homeowners About to Hit the Lottery?

If you're one of the millions of homeowners underwater on your mortgage, listen up. Your fortunes may soon change drastically for the better.

According to Reuters columnist James Pethokoukis:

Rumors are running wild from Washington to Wall Street that the Obama administration is about to order government-controlled lenders Fannie Mae and Freddie Mac to forgive a portion of the mortgage debt of millions of Americans who owe more than what their homes are worth. An estimated 15 million U.S. mortgages -- one in five -- are underwater with negative equity of some $800 billion. Recall that on Christmas Eve 2009, the Treasury Department waived a $400 billion limit on financial assistance to Fannie and Freddie, pledging unlimited help.

It's worth reiterating that this is a rumor, and nothing more. The Treasury plans to hold an Aug. 17 meeting to discuss Fannie and Freddie's future, which would be an obvious time to either confirm or deny this speculation.

For the moment, let's assume they're true. Sounds like another devastatingly expensive taxpayer giveaway, no? Probably. But there's actually an argument that doing this could save Fannie and Freddie money. Studies are in fair agreement that the propensity for homeowners to walk away from a mortgage rises as their homes sink deeper underwater. If the rumored program is designed so that the cost of mortgage forgiveness is less than the amount Fannie and Freddie would lose in foreclosure (and it easily could be), it'd make a good amount of sense.

There's just one small problem …
At least, that's the theory. Reality is sadly different, and there's almost zero chance of what I just described happening in real life -- although it's the argument you can be assured the administration will give you to justify this program's existence. 

Since Fannie and Freddie don't know exactly who plans on walking away from their house, a principal forgiveness program like this would have to be extended to a blanket group of homeowners -- including those who have no intention of defaulting. When you add in the cost of paying these homeowners to not do something they never would have done in the first place, the total cost of the program could look godawful. Cash for Clunkers and the first-time homebuyers credit ran into the same problem. It's inefficiency like you can't believe.

But who cares? Spending a couple dozen billion on Fannie and Freddie is called a slow Tuesday in Washington. We should ask not what this program might cost -- it would inevitably be huge -- but how it might affect the housing market.

Hello, unintended consequences!
And, oh, how it would. I consider the unending battle on homeowners' behalf a carryover of last decade's bubble mentality, which insisted that homeownership ranked among life's most sacred treasures. If you're a renter and you get into trouble, you can go pound sand. If you own a home and you get into trouble, the government's got your back. That's a dangerous signal to send.

But that's the least of my worries (and I'm a renter). What would be seriously awful about this potential program is that, from the sound of it, it would only apply to mortgages owned or backed by Fannie and Freddie. No, there aren't details on how this program might work (or even if it's real), but this seems obvious: Fannie and Freddie can't order private lenders to forgive mortgage principal, after all.

That's dangerous because Fannie and Freddie only hold about 50% of the nation's mortgages. Private lenders (mainly banks) hold billions more:

Source: Company filings.
*Most recent quarter.

If Fannie and Freddie loans were granted principal forgiveness, while private loans were left to fend for themselves, the message to borrowers would be clear: If you need a mortgage, demand that it's backed by Fannie or Freddie. They're a one-way ticket to wealth, whereas private mortgages actually hold you to your word. In the end, borrowers' addiction to government-backed mortgages would be strengthened, at a time when most economists agree the long-term policy should be a gradual weaning.

So this doesn't just sound like a terrible idea. It sounds like a terrible idea that would set a terrible precedent.

Disagree? Sound off in the comment section below.