August 03, 2007

Mortgages and Sauerkraut

American Home Mortgage is going out of business quickly now. Like their subprime customers, they can't meet their debt obligations.

Are we Americans just nuts for taking on all this debt? Or is it rational?

A Free Kraut Story

The food stand near our local Costco used to put an open bucket of free sauerkraut near the ketchup and the relish. It was designed to make it a little easier and cheaper to get a deluxe hot dog with all the goodies. But they don't do it anymore - instead an hourly worker gets paid to dispense the kraut on your behalf.

What happened?

What happened was that cheapskate Asians like my family would say "ooh, free food!" and fill up the little plastic condiment cups with pickled cabbage goodness, and then sit and have saurkraut for lunch, sans hot dog.

No matter that the kraut was supposed to be for a hot dog. No matter that it wasn't intended to be eaten on its own and would give us a stomach ache afterwards. It was free, and so we'd do all sorts of unnatural things to take advantage of it.

"Only With a Hot Dog"

When a sign appeared that said "sauerkraut only with a hot dog," it just made things worse. Now we could assuage our guilt by buying a little $1 hot dog for the kids and then getting a huge drink cup to fill with $5 of free sauerkraut.

See, sauerkraut is sort of like discount kimchee. A lot of Asians eat pickled vegatables as a meal. And if you're a real cheapskate - well - we Costco members can smell a good deal from a mile away.

The problem with free sauerkraut is that, for a lot of people, free sauerkraut has nothing to do with hot dogs.

Houses are Hot Dogs

The mortgage tax deduction is a great American tradition because it gives people a discount on buying that first house that they can't really afford in cash. Just as Costco wants all its customers to enjoy tasty hot dogs, we Americans want our citizens to be proud homeowners. And so it really does make sense to give first time homebuyers a handout.

But somehow we messed up when designing the tax break. The deduction is a discount on the loan, not the house! I have no idea how that screw-up happened, but I guess that it's just like how it didn't occur to Costco that some people might want the sauerkraut more than the dog.

Giving away free stuff is a good way to discover what people are willing to consume.

And so over the decades we have discovered that Americans are quite happy to load up on discount debt. Even if the loans they get are not very good. Even if the end result is a lot of borrowed-money for shoes and cars and vacations and a foreclosed-on house.

It is not really about the house is it?

With an open-ended discount on mortgages, is it any surprise that people seem to be getting more debt with less house? Collecting free stuff from the government is a big industry, especially since every citizen can play. Bad credit? No worry - the more expensive the loan, the bigger the tax break.

Pass a bigger cup, and pile up on that saurkraut.

I have written about this before. We would all be better off if we got rid of this mortgage deduction. I wonder if the current mortgage meltdown will give us an opportunity to pull the trigger.

Posted by David at August 3, 2007 06:41 PM

Damn those cheap, tasty Costo hotdogs! I ate a Costo hotdog while on vacation in Hawaii.

And yet somehow I don't own a house either!

Posted by: Kevin Krouse at August 3, 2007 08:02 PM

You mean you have room to eat sauerkraut after Hoovering up all of the free samples in the store? :-)

As you know, the mortgage deduction is the result of a paternalistic government thinking that it knows best and attempting to redirect incentives toward ownership. In the government's mind, home ownership = good.

The unintended consequence is that there is discrimination against renters, which not only results in an undue discrepancy in the marketplace, but also negatively impacts our ability to HEDGE against imminent problems.

For example, if you were smart enough to recognize a housing bubble about to burst, you would sell your house at or near the top of the market, then buy again after the bubble had deflated. This is what you would do with almost any other asset class (even, say, shares in Google). But for housing, you, of course, still need a place to house your family. You could rent a house while waiting for the market to clear, but you're paying rent without the Mortgage Deduction! (Offset, admittedly, to some degree in the People's Republic of Massachusetts with the rent deduction on the state income tax.)

Thus, you have a disincentive to rent (all things being equal, it will cost more to rent the home you're living in than it would cost to buy, given the difference in tax treatment) - which only helps fuel housing bubbles.

Re your proposed solution, consider also the Flat Tax (go Estonia!) or a Consumption Tax (very good for us cheap Asians)...



Posted by: Dennis Liu at August 6, 2007 10:57 AM

It's very interesting that the deduction is only targetted to owning a home as that's desirable, but inflation is usually measured against rental costs. So, you can have huge inflation or deflation in the "desired" market of owners with smaller and smaller rental pools, and yet the inflation numbers look tame.

Posted by: Dave Orchard at August 10, 2007 07:44 PM
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