Shipman on the credit crunch
By Jim StergiosOctober 20th, 2008
Bill Shipman — chairman of CarriageOaks Partners LLC in Manchester-by-the-Sea and co-chairman of the Cato Institute Project on Social Security Choice — advanced an intriguing idea on how to “support housing prices and facilitate the market for toxic securities that ultimately are tied to housing” in a recent Investor’s Business Daily: Suspend the capital gains tax on toxic assets.
No tax on short- or long-term capital gains or other income realized upon sale of the asset through 2013 for any individual or institution that purchases either the distressed real estate or securities collateralized by the real estate. This idea will produce winners and no or few losers.
When the seller would keep all of the proceeds from the sale of a house, because none are taxed, the future value of the house is greater than if it were taxed. The present value, therefore, is also greater.
Stated differently, housing prices rise when taxes are reduced. An individual who has been thinking of investing in distressed real estate may now find the timing right. If he assumes that housing in his market would rebound within five years, he now has an incentive, at the margin, to buy.Institutions may provide a limited-purpose collective pool, such as a mutual fund, to buy distressed real estate, and then distribute the sales proceeds tax-free within five years. This structure would allow individuals who are not real estate professionals, but who nonetheless find the present housing market now more attractive because of the tax treatment, to easily participate and profit in its rebound. Private capital would enter the market, buy distressed property, and aid in re-establishing the market for housing.
Homeowners who are able to service their mortgage, but who are considering dropping the keys off at the bank, will rethink because their negative equity will shrink. Homeowners who are unable to meet their mortgage responsibilities would also benefit in those cases where the equity flips from negative to positive.
The securities collateralized by the real estate will increase in value as well, for two reasons. The first is that the collateral is now greater, therefore the risk is less. The second is that the gain on the sale of the securities is not subject to tax, therefore increasing the after-tax return to capital. Purchasing these securities from banks, an objective of the legislation just passed, would improve their balance sheets.
Shipman notes two objections he has heard:
The first is that investors would reap a windfall due to the tax treatment. This objection is a confirmation that the idea has merit because no windfall can accrue unless private capital invests.
The second objection is that it would cost the government money in the form of the lost income and capital gains tax. This is a red herring because the private sector isn’t investing, and without investing there can be no gain to tax. From the government’s point of view, not investing, or investing with no tax, yields the same zero revenue.
Elegant solution. Thoughts?
Entry Filed under: Better Government, Economic Opportunity, Housing, News
2 Comments Add your own
1. Liam | October 21st, 2008 at 10:03 am
Not only is it elegant, it is perfectly rational, which, unfortunately, may be its Achilles Heel. We simply don’t live in a rational society, at the very least one in which, if we all break even or make out, everyone’s happy. No, nothing bothers us more than the sight of someone getting ahead, even if we’re not falling behind.
In a recent article in Slate on why humans are so quick to take offense - http://www.slate.com/id/2202303/ - Emil Yoffe describes an experiment designed in 1982 to study negotiating outcomes.
The idea of the “ultimatum game” is simple. Player A is given 20 $1 bills and told that, in order to keep any of the money, A must share it with Player B. If B accepts A’s offer, they both pocket whatever they’ve agreed to. If B rejects the offer, they both get nothing. Economists naturally expected the players to do the rational thing: A would offer the lowest possible amount—$1; and B, knowing $1 was more than zero, would accept. Ha!
In the years the game has been played, it’s been found that almost half the A’s immediately offer to split the money—an offer B’s accept. When A offers $9 or even $8, B usually says yes. But when A’s offer drops to $7, about half the B’s walk away. The lower A’s offer, the more likely the B’s are to turn their backs on a few free dollars in favor of a more satisfying outcome: punishing the person who offended their sense of fairness.
2. L'avocat du diable | October 22nd, 2008 at 9:54 am
Liam’s comment is true on its face. Resentment of unequal outcomes, even those that don’t produce a loss, is well-understood to be widespread. However, I view this reaction to inequality as something that appears to be irrational in short-term, controlled, simple scenarios where the possible outcomes are known and presumed fair, but is really an important tool in the arsenal needed for survival in the real world, where information is incomplete and games often benefit others to one’s own real - rather than simply relative - detriment. This is without even asking whether status really matters. In short, it’s sometimes tough to tell the three card monte from the blackjack game out there, so it’s better to stay sharp.
I am not an economist, financial advisor, or heart surgeon, and I am not proffering any investment or culinary advice. I too strongly dislike the recent bailout attempt. However, this oped leaves me with a lot of questions.
a) it is vague in defining which assets are to be considered eligible for the shelter,
b) lacks discussion of moral hazard (keeping in mind that we can’t simply wipe the bailout from investors’ memories),
and c) we may be missing important innovations beyond our current understanding.
As for a), what exactly is a troubled mortgage or security? What is a member of this protected asset class? Can a speculator, in 2009, see an uptick in a local market, and use the tax shelter to get back in the flip game, or is the class limited to owner-occupied properties whose mortgages entered default by June 1, 2008? Assuming an uptick in public confidence, can a good salesman create new, tax-free assets out of securitized bum mortgages in 2009 that are long out of his/her risk window by the time the shelter’s up, or does a mortgage or security have to be in existence by a particular date in order to be eligible? The authority who is empowered to define these eligibility classes and how they do it will be the most consequential piece.
More questions: What percentage of the value of the sheltered mortgages and securities represent lost causes that no pro investor would presently touch even if given a tax CREDIT? Is the goal to help the attempt to secure the fundamentals on these assets? To make them better buys? To increase their market price?
I’m not an investments expert, but do we, as a national public policy objective, really want people buying assets with poor fundamentals for the sake of increasing their prices? I hope this plan doesn’t go for that. Also, if the objective is to increase home prices, that doesn’t do young people in Massachusetts very many favors, and belies the argument that there are few real losers.
As for b),
Correct me if I’m wrong, but it seems as though cutting taxes to stimulate the purchases of troubled instruments would not be likely to produce fewer of them. In the wake of the bailout, the message of this policy would seem to be a further rejection of the need of the investor class to watch what they invest in, and would not encourage future home buyers to think rationally about what properties that they can afford.
Help me out…I have a hypothetical, and I want someone to tell me if this is a fair assessment.
So, for example, the Hypothetical Honest Howards have had a mortgage for 12 years. They have made every payment on time. Their credit rating is high. They pay their property taxes on time. They have made real improvements to the property in which they have lived for those 12 years. They have not taken out a home equity line. While their mortgage is not in trouble, they have bills and debts. They have taxes to pay. If they sell their home, and elect to retire modestly, would they receive a capital gains tax break? The protected class that includes them would have to be very big - seemingly cost-prohibitive, right?
However, the Fictional Freewheeling Francis’ have had their share of ups and downs flipping properties. The Francis’ have a gamble to make: Sure, they have no interest in living in these houses, but they know that there is a strong chance that a mortgage they leave out in the cold for 3 months might make them eligible for a capital gains break if the regulators includes their class of mortgage and property as eligible. Is this a possible scenario?
As for c), I am not a finance guy, but an average guy might expect that there is more to this housing crisis than the elegant plan would suppose. Some smart people didn’t see the current storm coming, so let’s all be circumspect.
If one is going to make the large concession that the market requires government action to save a class of investment rather than letting the junk fail - not a step I’m willing to make policywise - and use tax policy to relieve burdens and let the government reward behavior, why not at least reward those solid citizens who played by the rules and lived within their means?
To answer Liam’s comments, even if the plan creates no immediate losers, which, by seeking housing price changes, would not seem to be the case, we risk providing incentives and tax shelters for recklessness. We risk making suckers out of those who saved, assessed risks, and paid their mortgages. Damn us if we do. We may also risk making new suckers out of those who foolishly hop into an investment with bad fundamentals because the government seemed to have given it a seal of approval with a tax shelter.
Liam, I wonder if Congress and experts’ desires to forgive would be so strong if we were discussing credit card debt or hospital bills or student loans. Probably not.
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