Americans rush to judgment on 'bailout'

Whenever government is involved in a program to assist a private firm in trouble, much of the press reports it as a "bailout." Back in the 1980s when the savings and loan industry was in trouble, the operations of the Resolution Trust Corporation (RTC), which the federal government chartered to manage and liquidate the assets of failed associations, were frequently, yet erroneously, described in this way, and they still are.

For readers who don't bother absorbing the details, the term "bailout" suggests that everybody connected to the troubled enterprise is being rescued, including those who were responsible for its plight. For this reason, it often generates a hostile public response -- "one more example of how government protects the big guys."

Until very recently, a core if unstated principle of federal government intervention since the 1980s has been that the shareholders of the firms involved lose all or most of their investment, and that some or all of the top executives lose their jobs. This was the case in the savings and loan episode, and it has been true of the recent interventions involving the investment bank Bear Stearns, the government-sponsored enterprises Fannie Mae and Freddie Mac, and the insurance conglomerate AIG. Those protected by the intervention have been the creditors of the firm and the employees, if the firm continues as a going concern.

The erroneous inferences hasty readers draw when they see the term "bailout" used in connection with a government intervention derives from the other common uses of the term. The most familiar one is bailing out a leaking boat, which protects everybody in the boat. It is not possible to bail for one but not for another. Similarly, only one pilot bails out of a damaged airplane, and one accused felon is bailed out of jail. In describing government interventions in connection with individual firms in trouble, we need another term that does not carry this baggage.

Ironically, as I was writing this piece, the news broke about the Treasury's planned program to provide general support to the market. The new program would buy distressed assets for more than they are worth, gifting the selling firms and receiving nothing in return. This program is quite properly described as a bailout.

Can a Small Reverse Mortgage Make Sense?

Because some fees on a reverse mortgage (RM) are a fixed amount, small RMs are quite costly. Nonetheless, they may be the best option available in some circumstances. Here is an example:

"My grandfather of 96 is in poor health but wants to stay in his house. However, he requires constant care, which the family cannot afford. We need to find about $1,000 a month. His townhouse is worth only $52,000 and it has a mortgage balance of $12,000. Would a reverse mortgage on his house be an answer for us? Would we have to pay off the reverse mortgage when he dies?"

On reading this letter, I was skeptical that an RM would be an answer, but after crunching the numbers and considering the alternatives, I changed my mind.

On a house worth $52,000, a 95-year-old can get a reverse mortgage of about $46,000, from which must be deducted about $6,000 in upfront fees, leaving $40,000 that can be drawn on. However, the $12,000 loan balance must be repaid out of this, leaving only about $28,000 available as a credit line to be drawn on as needed. Nonetheless, the RM will provide $1,000 a month for at least 28 months, which is exactly what the family needs.

There is no repayment obligation on a RM. If the borrower dies within the 28-month period, the lender will sell the house, repay the balance of the RM, and remit anything left over to the borrower's estate. If the borrower is still alive when the RM credit line has been exhausted, he can continue to live in the house, but the family will have to find another way to pay for his care.

"I am 72 years old; my mortgage is paid off; and I intend to live with my children in a year or two, at which point I will sell my house. In the meantime, I have some repairs to make and some credit-card balances I would like to pay off. I am thinking of taking out a reverse mortgage, then paying it off when I sell. Good idea or not?"

This is a bad idea. A reverse mortgage is not suitable for raising funds for a short period, because the upfront cost is so high. The appropriate instrument to use for your purpose is a home equity line of credit (HELOC), on which the upfront cost is low -- sometimes zero if you shop carefully.

The difference between the two cases is that in the first case the borrower will remain in the house, and there is no other fund source that will permit this. In the second case, the borrower intends to pay off the loan when he sells in just a few years, which makes the HELOC a feasible (and lower-cost) option.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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