Sunday, December 2, 2007

The Mortgage Bailout: Moral Hazard

The federal government is working with the financial industry to hammer out a proposal to temporarily freeze interest rates on troubled sub-prime and adjustable rate mortgages. Treasury Secretary Henry Paulson is scheduled to reveal the details of the plan at a national housing conference on Monday,

The major thrust of the proposal would be for lenders to extend for a number of years the lower, introductory teaser rates that were offered on subprime mortgages. Initial details suggest an extension of the lock period to seven years.

Over 2 million of those initial "teaser" rates are scheduled to rise to much higher levels by the end of next year. Many homeowners will not be able to meet the higher payments, likely triggering hundreds of thousands of defaults. Naturally this would dump more unsold homes on an already suffering housing market, pushing home prices down further, further jolting consumer confidence and increasing the probability of a full-blown recession.

Most of the hue and cry in the press recently focuses on the moral hazard of saving homeowners who made very bad choices, few articles focus on the absurdity of bailing out irresponsible banks.
Mortgage aid plan sparks hope and resentment

"It's not the government's job to bail them out."
"It feeds into the mentality that the next time you screw up, someone will rescue you."

These statements are even more applicable to the banks than to the stressed homeowners. In reality this plans is about saving the bacon of the banks. Since when does the government actually care about individual homeowners, this entire bailout is about salvaging the entire banking system from a crisis. The concept of moral hazard is even more applicable to bailing out these banks.

Some industry specialists such as Peter Schiff, president of Euro Pacific Capital present a more comprehensive perspective. He recently stated, "The rhetoric is 'We've got to help homeowners,' but the reality is it's designed to help the fat cats, Wall Street. It's bailing out the lenders."

Many historians view the Great Depression would have lasted a mere two years rather than ten if the government had allowed the implosion of the excesses of the financial system to run their downhill course. The intervention of the government to prop up banks and interfere with market activity caused the dismal economic conditions to linger for many years. Only the intervention of WWII caused a turn-around.

At this point it appears that the bail-out plan in some form is a sure lock. Major players in the mortgage industry such as Citigroup, Wells Fargo & Co. and Countrywide are on board. The holders of the CDO notes may cry about reduced interest payments. However CDO holders such as pension and hedge funds face a stark reality either getting paid nothing at all as the entire stack of derivative dominoes tumble or losing a portion of the interest. Most will gladly grab the horns at this point and accept the reduced payments. It is likely that only the lower tranches will suffer and the higher tranches get paid first, leaving only the holders of the lower quality segment of the mortgage derivatives out in the cold.

Maybe this time, the U.S. should simply allow the excesses to be washed out of the financial system. The pain, however sharp, will last for a shorter period of time then a continually cycle of bailouts. Wall Street has a long history of ignoring risks in order to make a quick buck; this leads to constant repetitious cycle of poor financial management. The game ends the same each time; with individuals left out in the cold, the financial firms propped up, bankers flashing big bonuses while every taxpayer is zinged, and another cycle of unnecessary government intervention. Is it time to steer a new course?

An earlier post discusses the moral hazard of bailing out Citi
Should Citi Pay for its Mistakes