How the government can help

As many people may know, the Fed has changed its long-standing policy of being the lender of last resort only to regulated-commercial banks. This turn became apparent with the backed rescue of Bear Stearns two weeks ago. They have provided the credit market with liquidity and has done its job of making sure the credit markets don't completely collapse, along with any consumer confidence in the markets. But what of the housing market? Is there anything the government can do to facilitate the recovery of the housing market? We read of Hillary Clinton's call for the government to buy up sub-prime mortgages and Barack Obama's call for additional stimulus money (about $30 billion last I heard). Most approaches from the fiscal side embraces the idea of the state solving the problem. I propose that they not solve the problem per se, but do their part to allow the market to solve the problem itself. What I speak of is the real estate short sale and what the government can do to facilitate them.

A short sale is when a homeowner sells his or her house for less than what they owe on the house. This leaves a remainder for the houseowner to pay. In a short sale, the bank can agree to forgive the remaining debt on the mortgage basically in exchange for the home being sold. The down side of this deal is that the difference between the selling price and the mortgage debt is taxable income. In some markets, houses are losing hundreds of thousands of dollars in value. That is a lot of money to be added on someone's tax return as income. So much so in fact, that homeowners may still choose bankruptcy or foreclosure because they cannot afford this loss. This is where the government can help.

A well-regulated fiscal policy by the US government can forgive that loss through legislated tax policy. The government through its tax policy can facilitate short sales all over the country. If that loss is not counted as income, then this may lubricate the market better than any liquidity policy by the Federal Reserve.

This will revive the real estate market in several ways. First, it will allow buyers to enter the market again through short sales. Banks, needing better collateral to loan again, will have a lower price to loan a potential buyer. A lower price means a higher likelihood of having the 10-20% down on a new home. The mortgage market can move away from the fast-cash, no collateral, interest-only ways toward a more stable credit market with buyers with better credit. Second, this prevents the banks from taking on countless assets on their balance sheet through foreclosure, which will be sold at a loss anyway. Why not take that loss upfront, with someone not only still occupying the house, but still paying a mortgage? It may be less, but it is a lot more than if the bank was forced to bear the costs of foreclosure. Lastly, it will guide the housing market toward a more natural equilibrium. No one can argue that the housing market was inflated by the time of this downturn. A downward correction is needed, encouraging short sales will facilitate this correction.

If the government regulates these short sales to prevent misuse and fraud (and this is a big IF), then tax-forgiveness can be the lubrication the real estate market needs to move toward stability. A poorly regulated financial market, facilitated by the Fed's cheap money policy from 2001 to 2007 caused a white hot rise in real estate prices. They are coming down, and some argue they have further to fall. Now, this can be an absymal crash or it can be guided landing. The government has the fiscal authority to change tax law. Forgiving this mortgage debt is how the state can help. It is a minimal intervention, but it can have maximum effectiveness if it is done soon. The state will intervene at some point, let's just hope it is with the feather touch and not the iron fist. We may all lose in the end if that fist comes crashing down.