The Radical Solution

We're not there yet, but we're getting there. Ben Bernanke so far has been financing the Fed's bailouts of investment banks and their hedge fund clients with real assets, not inflationary play money. But political pressure continues to build for more toxic medicine.

No wonder economists of diverse ideological stripe are lining up behind a taxpayer bailout of homeowners and lenders, fearing the alternative is a global inflation crisis. But another option has hardly been considered in Washington, though it's old hat in the sticks: Using tax dollars to buy and demolish foreclosed, unoccupied or half-built houses in selected markets.

This isn't as wild-eyed as it sounds. Ben Bernanke pointed out in a footnote to a recent speech that such programs already are at work in the Midwest. "In highly depressed housing markets, the worst-quality units are often demolished to mitigate safety hazards and reduce supply."

Baltimore has been praised for efforts to keep borrowers in their homes, but little mentioned is a program of demolition of foreclosed homes. Cleveland spends $6 million a year to demolish buildings. Dayton plans to demolish 550 this year. Only a small mental adjustment is required to begin aiming these bulldozers at "new" homes too. Get over it.

Knocking down surplus homes would be the most efficient and equitable way to spend taxpayer dollars. It can proceed experimentally. It can be turned off quickly when the need evaporates. It would not be a lesson to Americans that housing debt is not real debt and need not be repaid. It wouldn't benefit the most irresponsible lenders and borrowers at the expense of responsible ones. The housing market would still have to hit bottom, but the bottom would be higher (and sooner).

Have no illusions about the alternative being fashioned in Congress. Behind the fig leaves that will be frantically waving, a lending bailout would be effective in stemming foreclosures and propping up home prices only if taxpayer money were used to put speculators' housing bets back "in the money."

Yes, a few hardship cases might benefit, but a federally subsidized mortgage haircut won't bring back a job, restore a breadwinner to health or patch up a divorce – the circumstances behind many of the million or so foreclosures that take place even in a good year. Today's foreclosure panic is due largely to the anomalous factor: Lenders and borrowers who crafted a new kind of mortgage for the purpose of betting on home prices. It pays off if house prices go up and is easily walked away from, leaving bondholders with the loss, if prices fall.

Would such "homeowners" even cooperate in their own bailout? In 2005, fully 15% of new mortgages were of the "no downpayment, no income documentation" variety – i.e., were bets on rising home prices. These borrowers aren't walking away because of interest-rate resets or income loss, but because they don't want to throw good money after bad.

Another possibly fatal question is whether such a plan would ever get off the ground once Congress and the media started poking holes in the inequities involved. Legislators now recognize the problem but can only chase their tails. Their latest twist would require participating homeowners to share any future home-price profits with their lenders – which, of course, just reduces the incentive for on-the-fence homeowners to stick around.

Let's get real. So much of the subprime-financed overbuilding was concentrated in four states – California, Florida, Nevada and Arizona – that the Mortgage Bankers Association, which collects the numbers, says they "skew the national data." Parts of Florida now have an 80-month surplus of condo inventory. Hovnanian Enterprises, the big home builder, has mothballed a dozen half-built "communities" yet has no intention, its chief recently told a conference call, of repeating its "deal of the century" sale last year that drastically cut asking prices.

This supply overhang in a few key states, in turn, poisons the market for undifferentiated securitized mortgage debt, which has been the source of persistent instability in global credit markets.

Most of all, a demolition strategy would not add to the policy screwups that are a major but little mentioned contributor to the current troubles – the massive, relentless subsidies that Washington dishes out to rich and poor alike as a reward for incurring housing debt.

Put aside the question of whether the financial system really needs an outside subsidy to survive the losses of the housing downturn. Put aside whether bailout talk only deters banks from raising the needed capital (as UBS and Lehman are now doing) to work off their problems to the satisfaction of creditors and counterparties.

At the moment, we're headed in exactly the wrong direction. Fannie, Freddie and the Federal Home Loan Bank System are being told to throw more billions at mortgages. Moving through Congress is yet another subsidy for home buying in the form of a tax credit. Even the Fed's opening of its discount window to investment banks is a signal to the banks' own lenders to exercise less discipline.

We will survive today's crisis even without heroic action from Washington to refloat the housing market. Worse than no solution, though, would be one that greatly increases the subsidy to risk-taking already in the system.

And think about this: Of the nation's $11 trillion in housing debt, at most about $1 trillion is "unfunded." How much more likely is the political class to fail us when confronting $99 trillion in unfunded entitlement liability?