Will the Federal Government Response to the Mortgage Crisis Pick Taxpayers' Pockets?

On Tuesday, December 4, 2007, the financial press reported that the Bush Administration had proposed that states and municipalities be authorized by Congress to issue tax exempt bonds to raise money for refinancing distressed homeowners unable to pay their mortgages. The aroma of a taxpayer-funded bailout of the mortgage crisis has been in the air for a while, and now we see the first concrete manifestation.

Details about the proposed bonds were not provided. However, one could reasonably expect that they would be revenue bonds, where the states and municipalities issuing them would have no liability for repayment. No government in its right mind would today assume liability for anything that's mortgage-backed. Governing bodies would simply lend their official status as a means of providing a tax exemption. The investors' right to repayment would presumably come only from the refinanced mortgages.

Given the toxicity of the phrase "mortgage-backed" these days, how could such a program work? The number of people clamoring to invest in mortgage-backed securities wouldn't fill a phone booth. But here's a likely scenario: the tax exemption would allow the bonds to pay a relatively low interest rate. Investors will accept lower returns when those returns aren't taxed. This would allow distressed homeowners to refinance at low rates they can afford. Since these refinanced mortgages wouldn't need to find a home in the ordinary market for mortgages (in which interest is taxable), they can be used to bail out distressed borrowers and still be sold to investors. Sounds like a win, win combination, yes?

No. In spite of all the brilliant financial engineering available on Wall Street and a Federal Reserve Board that talks tough, but hands out candy on demand to the financial markets, there still ain't no such thing as a free lunch. If tax exempt bonds ride to the rescue, giving both distressed borrowers and investors a break, someone else has to be paying for lunch.

And that would be John and Jane Taxpayer. Tax exempt bonds would increase the amount of interest income that isn't taxed. There would be a negative impact on federal tax revenues. Either taxes will have to be raised, federal borrowing increased, or both. If federal borrowing increases, greater interest costs will be borne by taxpayers.

The burden won't be spread evenly among taxpayers. People who invest in tax exempt bonds typically are wealthy or very wealthy. Most taxpayers are neither wealthy nor very wealthy. So ordinary people would pay the price of a mortgage bailout while wealthy investors get a tax break.

Tax exempt revenue bonds have been used for decades to finance industrial development, hospitals, pollution control equipment, and other activity deemed socially desirable by the state or municipality issuing the bonds. However, they've typically been used for relatively small projects, where millions or tens of millions of dollars of bonds were issued. A bailout of the mortgage mess would probably require tens of billions, or even hundreds of billions, of dollars of bonds. Such a program would shift a vast amount of capital from investment in taxable bonds and other debt investments into mortgage bailout bonds, with a large, regressive impact on taxpayers.

It may be that the tax exempt bonds proposal is just political football. The Republicans know that any such program cannot be adopted without Congressional action. They also know that the Democrats have a policy of tax revenue "neutrality," where the Democrats would not approve any tax cut or spending measure without a way to offset the revenues that would be lost. There may be no feasible way to find enough offsetting revenues to compensate for the revenue losses of a meaningful tax exempt bond program for refinancing distressed homeowners. So Congress may be unable to act. Then the Republicans would blame the Democrats for their inaction. And that may all there really is to the tax exempt
bond proposal--more political gotcha and fingerpointing.

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