Subprime Bailout: Taxpayer toll

NEW YORK (CNNMoney.com) -- Lend a hand to distressed homeowners? No way, say many, who worry the tab will come out of their pockets as taxpayers.

Some proposals, it's true, would be directly financed by taxes. For example, the Senate voted in favor of an appropriations bill that earmarks $100 million to provide housing counseling for those facing foreclosure.

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But some proposals would cost taxpayers money only in a worst-case scenario.

Taxpayer dollars, for instance, don't directly support the Federal Housing Administration's loan insurance program - the premiums paid by homeowners with FHA loans do.

But moves to liberalize FHA loan guidelines concern some because the government would presumably step in if the FHA stumbles after taking too much risk.

In the wake of the credit crunch, the agency instituted FHASecure to loosen guidelines to make more FHA loans available to homeowners in trouble. A modernization bill under consideration would allow the agency to insure bigger loans and loans with 0 percent down.

Those provisions would expose the FHA to more expensive and more risky loans. If too many of those loans fail, the thinking goes, the government would step in with taxpayer money.

"While the subprime market has witnessed considerable stress, the losses in that market are being borne by investors. Were these same losses to occur in FHA programs, it is likely they would be borne by the taxpayer," said Richard Shelby (R-AL), ranking member on the Senate Banking Committee, in a July hearing.

Other proposals on the Hill focus on Fannie Mae and Freddie Mac. The agencies guarantee the purchase and trading of mortgages, which helps promote homeownership. Fannie and Freddie can't buy loans valued above $417,000 and some proposals call for an increase in that limit.

Some proposals also call for higher limits on the amount of mortgage assets that Fannie and Freddie buy and keep in their own portfolio, and earmarking a portion of the raised limit for the purchase of subprime loans.

Fannie and Freddie are "government sponsored," not government funded, but there is an implicit understanding that should Fannie and Freddie falter, the government would feel pressure to help out.

"As a purely legal matter, it's not required to. But it's bailed out private companies before," said Patrick Fleenor, chief economist for the Tax Foundation, a nonprofit research group that advocates for lower taxes.

Some bills would impose more stringent regulation on mortgage lenders and brokers, and administering such oversight would cost the government money.

But even those who oppose tax-funded bailouts say more stringent regulations is a good idea.

"Government cannot stop the housing market from expanding and contracting, but it can make future contractions less painful ... [by holding] lenders and brokers to higher, more uniform standards during loan origination," wrote economics and public policy associate professor Jacob Vigdor of Duke University in a paper critical of most bailout proposals.

There is a bill that would amend the bankruptcy code to let judges reduce the value of a mortgage to the value of a home for Chapter 13 filers. That cost would be borne most directly by lenders. But lenders could price that risk into the price of loans, making it more expensive for consumers to buy a home.

One proposal, while directly tax related, is not likely to affect most taxpayers. The Mortgage Forgiveness Debt Relief Act (MRDA) would exempt homeowners paying income tax on any mortgage debt their lenders forgive. That would reduce federal tax revenue by an estimated $1.3 billion over 10 years, but another provision in the bill would actually raise more money, making the bill revenue neutral, according to the Joint Committee on Taxation.

That money-raising provision would reduce the amount of capital gains some second-home owners may exempt from tax when they sell that second home.

Some initiatives are not at all funded by taxpayer dollars. One example is that the newly formed alliance among a select group of mortgage lenders, servicers and housing counselors brokered by Treasury Secretary Henry Paulson. The alliance will coordinate efforts between servicers and counselors to provide subprime loan "workouts," which can include lowering the interest rate on a loan, spreading out past-due payments over the life of the loan or a short-term repayment plan.

Another example is the Treasury-facilitated debt rescue fund financed by three major banks to enhance liquidity in the short-term credit markets.

But those who oppose bailouts say it's as much about principle as it is about cost.

"Using government power to absolve borrowers or lenders of their responsibility, even without the direct use of taxpayer dollars, is likely to be costly to many, hurtful to the innocent and helpful to those whose avarice and overreaching contributed so much to the creation of this situation," Vigdor wrote.

Those who are more supportive of such efforts say the cost to everyone could be much greater by not doing anything.

Correction: An earlier version of this story incorrectly stated that Massachusetts was using taxpayer dollars to help troubled subprime borrowers refinance their loans through a foreclosure prevention program. The program will be partly funded by issuing taxable bonds, but those bonds will be repaid by MassHousing using money generated from that agency's mortgage loan business. MassHousing was created by the state legislature but is self-funded, said spokesman Tom Farmer.