I’m a bit late on this, but I think last week’s $26 billion foreclosure “deal” with the banks deserves some scrutiny (check out Charlotte’s take here!)

From the Wall Street Journal:

Government officials have finalized an agreement worth as much as $26 billion with five major banks, capping a yearlong push to settle federal and state probes of alleged foreclosure abuses by lenders.

The planned pact would involve around $5 billion in cash penalties, payable to borrowers, states and the federal government. That includes $1.5 billion in cash payments to borrowers who went through foreclosure between September 2008 and December 2011. Borrowers could receive $1,500 to $2,000 each, with the actual amount paid depending on the number of borrowers filing a claim.

The agreement is expected to call on the banks to provide $20 billion in other aid—by cutting loan balances for tens of thousands of homeowners and by refinancing thousands of borrowers who are current on their loans but owe more than their homes are worth.

To restate: the government is trying to give homeowners – who were already underwater on their mortgages – a chance to refinance and start again. That’s a nice objective… but it’s not the right thing to do.

Sure, there are a number of sad stories… but frankly, these people weren’t coerced into their home loans. They knew the terms of the contracts and signed anyway – because they made an (erroneous) assumption that their homes would always appreciate in value. Essentially, we’re bailing out irresponsible citizens at the expense of responsible ones – and that’s called moral hazard. Think about the message that’s being sent to Americans – "if you mess up, Uncle Sam will be here to set things right." That’s awful!

Furthermore, in forcing banks to foot the bill for this scheme, they're reducing banks’ reserves – which are funds that would be used to provide loans to future, qualified borrowers. This is redistributing from one constituency (future homeowners) to another (existing homeowners).

To date, the government’s modification programs have been ineffective in reaching people. Alas, there’s no chance that their efforts will be more efficient this time – because we're not addressing the underlying problem of an overinflated market where risk is subsidized – i.e. ENCOURAGED – by government-sponsored enterprises. To truly fix the problem, we need to get the government out of the mortgage-guarantee business, so that banks are forced to honestly assess the riskiness of loans – and only extend loans when it makes business sense.