From Wall Street to Orange County, from the exurbs of Dallas to the South Beach strip, a cry is rising from throughout the land: Something must be done about the nation's housing market!
Washington has been struggling mightily to respond. The Federal Reserve is promiscuously extending credit to banks and Wall Street; Fannie Mae and Freddie Mac are boosting the size of mortgages they'll buy; and the White House has orchestrated a voluntary industry effort to stave off the rising tide of foreclosures. Concerned that these extraordinary measures still aren't sufficient, the president and Congress are now considering new moves to help the beleaguered industry, with the Senate set to vote tomorrow on a package of new tax breaks and assistance.
Even with this flurry of activity, many critics, particularly Democrats, have argued that the government isn't doing enough. But the package under consideration suggests that it may be doing too much. The bill includes several items that are likely not to do much harm—boosting deductions for property taxes, tax-exempt bonds for local housing agencies, and modest tax credits for people who buy homes out of foreclosure. But it also includes a provision, detailed in this Associated Press story, that is perverse, absurd, and unwarranted. In short, I don't think it's a good idea.
Under the proposal, the AP reports, "companies would for two years be allowed to carry back losses incurred in 2007 and 2008 against profits accrued over the previous five years, instead of the usual two year timeframe." Under current rules, companies can effectively call up the Internal Revenue Service and declare a do-over, applying losses racked up in 2008 against income reported in 2007 and 2006, and then claim a retroactive tax refund. The utility of this benefit rises as the size of the loss increases. If, for example, you're forced drastically to write down the value of land you've acquired, the loss in 2008 could easily swamp the profits reaped in 2007, 2006, and several years before.
The technical term for this is a tax-loss carryback. But it should perhaps be known as a bubble-head tax break. Companies that vaulted into a hot sector and then used lots of leverage to increase their profits in said sector (the Internet, real estate) light up the charts during the boom years. But come the pop, their fortunes plummet rapidly down the same steep slope. And because accounting rules require companies to mark assets to market, erstwhile high-flyers frequently report massive losses.
The proposed tax break is hard to justify for several reasons. It does nothing for slow and steady companies that keep their heads and simply rack up profits year after year—and pay their taxes accordingly. Rather, it rewards the most reckless participants in the bubble. If you borrowed a ton of money to build spec houses in Miami and reported $2 billion in profits between 2002 and 2007 but gave up all those profits by notching a $2 billion loss this year, the extended carryback has a great deal of value. If you've been building affordable housing in Wichita, Kan., and booked $300 million in profits in those years, and then, through careful management of costs, managed to eke out a $5 million profit this year, it has no value. The big public homebuilders, whose shares rallied on the news of this potential tax break, didn't pay any windfall taxes on the bubble-era earnings. Why should they get an extraordinary post-bubble windfall?
Homebuilders argue that they need relief because their sector, which provides a great deal of domestic employment, is on the ropes, and they're finding it more difficult to raise capital. Which is as it should be. After bubbles pop, those who screwed up really badly fail and get taken over by creditors or opportunistic investors. Those who have sound underlying franchises but merely got a little carried away can survive if they take painful restructuring moves. This is what is known as market capitalism. For all the talk of a credit crunch, capital is still available—it's just not available on the easy terms managers had come to expect during the late Greenspan years. Citigroup, Merrill Lynch, and plenty of other firms tied to the mortgage/finance complex have taken steps to shore up their balance sheets and replenish lost capital. But investors, having been burned, demand more downside protection and better guaranteed returns. Thornburg Mortgage was forced to pay 18 percent interest for an emergency round of capital raising that allowed it to stave off bankruptcy. This is also what is known as market capitalism.
Homebuilders should look to the capital markets first, rather than to the government, especially when their financial situation is serious but not critical. The stocks of potential beneficiaries of the expanded carrybacks—big homebuilders like Lennar, Pulte, and KB Home—have plummeted. But they're nowhere near bankrupt. KB Home is losing money, but it still has a market value of more than $2 billion. And it's still paying a decent dividend.
Finally, in many instances, the largest shareholders—and hence the biggest beneficiaries—are the managers who made the decisions that caused the losses. Toll Brothers, which is now racking up losses after years of profits, is valued at close to $4 billion. Founder Robert Toll has 17.5 million shares of Toll, worth about $440 million at current prices, which works out to about 11 percent of the company. At Hovnanian (first quarter loss $131 million), members of the Hovnanian family own at least 15 percent of the outstanding stock, according to Yahoo Finance. These companies—and their extraordinarily wealthy managers—still possess the financial heft to finance the recoveries from their self-inflicted wounds.
The proposal to give new tax breaks to homebuilders and banks is yet another example of the pernicious trend of privatizing profit and socializing losses, which is gnawing away at faith in the system. Dilute the shareholders, not the taxpayers.
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