Taxpayers Shouldn’t Pay for Mortgage Blunders

Bailouts create a moral hazard and spread the problem to more people

By Isaac M. Morehouse

Once again, I have to be the big jerk around the PI blog and disagree with one of my fellow bloggers. But hey, what kind of discussion can we have if everyone agrees?

Mike Getlin’s post yesterday chalked up the sub-prime ‘crisis’ (I hesitate yet to call it a crisis) to, basically, greedy profit-seekers who lacked foresight and made risky loans then sold them to other greedy profit seekers.

This certainly seems plausible. What loan agent is not interested in making more money by closing on more loans? What investment firm doesn’t want to see greater returns? If these parties took undue risk – either because of greed or any other reason – that's their choice so long as they reap the benefits or the costs. No one forced the firms to buy these sub-prime loan bundles. If they fall apart, those who took the risks should bear the cost.

Yet Getlin, after detailing how nearsighted and foolish these transactions were, went on to approve Uncle Sam putting every responsible and innocent citizen on the hook to cover the losses. It would seem if the behavior of these lenders and investors was too risky, they should take the hit when it doesn’t pan out.

Another missing piece was the fact that borrowers are not forced to borrow more money than they can reasonably pay back. One could take the line, as Barack Obama has, that these borrowers were simpletons and were hoodwinked into thinking they could afford more than they could by greedy lenders. No doubt there is some truth to this. But besides the fact that no lender wants to make a loan that will default (even if they plan to sell it, they still have to convince an investor to buy a bad loan and they get less for it) there are some things about these borrowers that deserve mention. Steven Malanga writes in an article from Real Clear Markets of a study that found:

“Mortgage fraud...had soared in America, especially in states with a high concentration of subprime mortgages. From 2001 to 2007, in fact, reports by lenders to the federal government of suspicious activity on mortgage applications had climbed more than 10-fold to 46,717. Moreover, those numbers merely hinted at the full extent of the problem since they only included information submitted by federally-insured institutions, and only represented fraud that lenders uncovered. By one estimate, total losses from fraudulent mortgage applications were estimated to be about $3 billion annually—and growing. The deception was clearly widespread, including false statements on mortgage applications about family income and current levels of indebtedness, submission of phony documents, and lying about the intended uses of the property that was being purchased.”

Clearly, we’re dealing with more than just greedy lenders. A huge number of the borrowers of subprime mortgages knew exactly what they were doing. In fact, Malanga also points out that many of the bad loans were made to borrowers who lied and said they were occupying the property (to get a lower rate) when in reality they were an investor seeking to flip the house.

“We don’t know exactly how many additional defaults can be attributed to occupancy fraud, but some studies have suggested the misrepresentations were widespread. Fitch Ratings, for instance, looked at a portfolio of 45 subprime loans that defaulted within their first year and found that in two-thirds of the cases borrowers never occupied the property, though they said they intended to.”

I have no problem with investors taking a risk on a house flip – I did it once myself. I do think that such investors should take the rewards AND the losses on their risk. The article also notes how in one study, 60 percent of the subprime loan applicants lied about their income. This persisted for some time because, “lenders naively believed that borrowers wouldn’t lie about income to qualify for loans that they couldn’t afford to pay back”.

Considering both borrowers and lenders are guilty of risk taking, and in some cases deception, should give us pause before we bail anyone out – that includes firms like Bear Stearns who bought the junk mortgages. E.J. Dionne Jr. writes in Investor’s Business Daily of what a bailout inevitably leads to:

“"It's not fair," argue the housing interests and consumer-advocacy groups. "Bear Stearns got a financial bailout, so why shouldn't we?" And they're right, by the simplest schoolyard definition of fairness.

So the line grows of people demanding breaks on financial obligations they can't afford. The Bush administration last week agreed to rescue 100,000 homeowners who are at risk of foreclosure on their mortgages.

Congressional Democrats promptly announced that this wasn't fair enough, and that they intended to expand the bailout to as many as 2 million distressed borrowers.

But why stop there? What about onerous commercial mortgages? And credit card debt? And student loans? Why should anyone have to pay back anything? It's not fair.”

Indeed, such bailouts create what economists call a ‘moral hazard’. This is when government (i.e. taxpayers) steps in an takes the consequences for an individual's or group's risky behavior. This sends a strong message and creates an incentive for people to take greater risks than they otherwise would, knowing that they will not have to individually suffer the consequences. If unwise lenders and deceitful borrowers get bailed out courtesy Unlce Sam, you can bet there will be more risky behavior to come.

Finally, I disagree with Getlin’s premise that all this malinvestment was simply a result of greedy bankers, or even as I’ve shown above, stupid borrowers. There is a deeper reason why both parties were willing to take such big risks – because, thanks to the Fed, they did not think they were taking as much of a major risk.

Economists like Ludwig von Mises and F.A. Hayek predicted this kind of ‘bubble’ behavior, and the current housing situation mirrors their theories almost perfectly. As Robert Murphy writes for the Mises Institute:

“The case against the Fed is straightforward: In an attempt to jumpstart the economy out of recession, Greenspan slashed the federal funds target from 6.5% in January 2001 down to a ridiculous 1% by June 2003. After holding rates at 1% for a year, the Fed then steadily ratcheted them back up to 5.25% by June 2006. The connection between these moves by the central bank, versus the pumping up and popping of the housing bubble, seemed to be more than just a coincidence. On the contrary, it looked like a classic example of the Misesian theory of the business cycle, in which artificially low interest rates lead to malinvestments, which then require a recession to correct.”

Add to that the Congressional penchant for making policy that ensures people who cannot afford houses will get them. But don’t worry, government officials are looking to the Federal Housing Administration as savior. According to The Heritage Foundation:

“[A] New York Times report notes that the FHA is no shape to rescue anybody. Indeed, it’s “grappling with financial woes of its own” and may have to be bailed out by taxpayers, too. The agency already faces a deficit for the first time in its 74-year history – a $1.4 billion shortfall as of this coming October.”

Go ahead, pile on more bad investments, we taxpayers don’t mind!

Bottom line: irresponsible government activity sends mixed-up market signals. A (very few in reality) borrowers and lenders act unwisely, partly under the influence of this policy. Investment firms choose to buy the risky mortgages. I fail to see a compelling case for putting the burden of these mistakes on the shoulders of the great majority of responsible citizens.

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written by Rahn, April 15, 2008

I agree that there is no sole fault in this, but the companies do have a part and the govt. bailout absolves them nicely for their hubris. The problem is lack of regulation and transparency in accounting. Bear Sterns DID need a bailout to avoid major financial issues system-wide, *but* without better controls by the govt. the problem will re-occur. If you want to get angry, get angry with the "elected" officials that give out our money to cronies and NOT backing it up with tighter regulations, controls or transparency. THATS what should be pissing people off about this whole mortgage situation...

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written by M. Harrison, April 16, 2008

Issac,

I have to disagree with you on this one. I think you misunderstood Mike's point.

Mike wasn't talking about the bailout of reckless borrowers - he was talking about the bailout of Bear Stearns. Even William Niskanen of Cato agreed that the Bear bailout was necessary because for the sake of the stability of the financial system.

Given the issues Mike mentioned of OTC derivatives and other unique features, the risk of these bad loans has been spread through the entire economy. That means the collapse of Bear Stearns threatened all of us - not just reckless borrowers.

The bailout of Bear was the least bad option available. I'm sure Mike would agree with you and I that bailing out reckless borrowers is irresponsible. But that's not what his article was about - it was about preserving the very stability of the financial system that underpins our economy.

Keep up the great work man - let's keep the debate going.

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written by IMM, April 18, 2008

I fail to see how it is logically consistent to not support of bailout of individuals, but to support one of Bear Stearns.

Check out this post on why this is a problem by my favorite economist, Russel Roberts - http://www.invisibleheart.com/...php#000088

On the comment about more regulations needed - I strongl disagree. The amount of regulation currently in place is already too much to be possibly complied with, more would be dog and pony and nothing greater. The market disciplines far better than any bureacrat ever could.

Additionally, thanks to Sarbanes-Oxley, one of the dumbest and most damaging acts of the last decade, you are already seeing, and will continue to, far more IPO's taking place in London, not the US, because Sarbox is already impossibly complicated.

It doesn't create accountability or transparency - in fact, it makes investors less keen because they feel like Uncle Same is "taking care of it".

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