Subprime Bailout: Good Idea or 'Moral Hazard?'

[profette_IHB]

<p><strong><a href="http://www.npr.org/templates/story/story.php?storyId=16734629">'A Subsidy for Risky Behavior'</a></strong> </p>

<p><em>from NPR.org, </em><em>November 29, 2007</em> </p>

<p>"Those opposed to government intervention of any kind in the subprime crisis like to quote industrialist Andrew Mellon, who, during the Great Depression, urged President Herbert Hoover to "purge the rottenness out of the system." In other words, the upheaval in the lending industry might cause some short-term pain but in the end, the economy will emerge healthier. </p>

<p>A federal bailout of shaky subprime lenders would amount to a "subsidy for risky behavior," says Christian Stracke, a senior credit strategist at the research firm CreditSights. "You would encourage future risky lending and borrowing by signaling that in extreme circumstances, the government … will bail out bad lenders," he says. </p>

<p>"Bailing out the lenders is unconscionable," agrees Kathleen Day, spokeswoman for the Center for Responsible Lending, a nonprofit research group based in Washington, D.C. "They made buckets of money on these subprime loans, and now they need to suffer the losses. In a free market, you should feel the pain" and pay for your mistakes, she says.</p>

<p>Perhaps in a perfect world, but some industries, indeed some companies, are so integral to the U.S. economy that they cannot be allowed to fail — nevermind how they got into trouble in the first place, argue others. The "too big to fail" theory came into play a decade ago, when the Federal Reserve intervened to rescue the giant hedge fund Long Term Credit Management. The fund, initially a huge success when it was founded in 1994, lost more than $4 billion in 1998. The Federal Reserve put together a bail-out by the major creditors to avoid a wider collapse in the financial markets."</p>

<p><a onclick="javascript:window.open('/templates/common/image_enlargement.php?imageResId=16744492' , 'imageEnlargementPopup', 'scrollbars=no,location=no,directories=no,status=no,menubar=no,resizable=yes' )" href="javascript:void(0);"><img class="photo border" alt="Conceptual image show sa mannequinn holding up a house made of cash" src="http://media.npr.org/news/images/2007/nov/29/bailout225.jpg" /></a></p>

 

[IrvineRenter_IHB]

It sure seems to be a moral hazard problem. The main reason everyone should avoid adjustable rate mortgages is because they adjust. If ARMs become fixed by government action, in all likelihood, they will disappear. If there is no distinction between a fixed-rate mortgage and an adjustable rate mortgage, the adjustable rate mortgage ceases to exist. ARMs have lower rates than fixed because the lender is shifting interest rate risk onto the borrower. If this shifting of risk is not permitted, then ARM rates will quickly rise to match fixed rates because they will basically be the same loan.





An interest rate freeze is the death of adjustable rate mortgage.

 

[Anonymous_IHB]

<p>It seems like a moot problem. Don't forget the recession? coming ...</p>

<p>Exerpt from comments on http://latimesblogs.latimes.com/laland/2007/11/white-house-ban.html</p>

<p>TakeFive,</p>

<p>I think that's a great point you made about the "disgust" many current homeowners have. I actually am one of them. My wife lost her job last month and is having a tough time finding another one. We have some savings and could continue to drain it to pay the mortgage, but we're probably $50-$100K upside down at this point with no end in sight. We sat down together the other night trying to come up with a plan that would be best for us and our family and unfortunately foreclosure looks like the best bet. It's sad and more embarrasing than anything, but we made a bad decision, have tried so hard to stay afloat but in the end we don't know what we're fighting for.</p>



<p class="comment-footer">Posted by: Andrew | <a href="http://latimesblogs.latimes.com/laland/2007/11/white-house-ban.html#comment-91850306">November 30, 2007 at 11:24 AM</a> </p>

 

[MalibuRenter_IHB]

I think we should be careful about the difference between "failing" and being "bailed out". There is a very broad range of circumstances where a company, its management, its employees, and its shareholders feel some real pain, but the company doesn't go under. It can be extremely difficult to try to get what you consider economic justice from a bailout. In many cases, justice is served in other ways. If there was genuine fraud, insider trading, etc., someone might actually go to jail. That does not bring back the lost money of investors.



Note that as you look at the large banks, some of them don't have much damage from subprime, alt-a, etc. They typically knew better, or retained more of the risk on their loan portfolio. While hindsight is 20/20, it doesn't take a PhD in econ to see that prices can't keep rising fast enough forever to keep bailing out noncreditworthy borrowers via market appreciation. Even if you just reflect on it for a bit, you see that flat prices would cause lots of foreclosures on 100% ltv homes. If you knew that you had a 2-5 year horizon before interest rate resets, the lender was making a bet that prices would keep rising for at least that long. Either that, or they stuck the buyers of the loans with that risk.



There is part of this debate that I haven't heard discussed much. When lenders retain loans, they typically are getting short-term funding via CDs, bank deposits, etc. If interest rates drop, and especially if there is a strongly sloped yield curve, existing loans get more profitable. Even better, the mark to market on a portfolio that includes some bad loans can take you above 100% of expected value. All you need to cover a 10% chargeoff is a drop in the bank's cost of funds by 10%. Going from 6% to 5% rates on CDs, bank deposits, etc., does that. This is a big benefit to a bank that doesn't have a huge portion of bad loans, and can help other banks stay closer to their expected profitability.



In contrast, most of the media coverage seems to think that the dropping interest rates are meant to prop up real estate values. It won't be much help in bubble markets like CA and FL. However, it will help banks stay solvent. With far fewer loans being made in 2008 than 2006, it's the existing loan profitability which matters most. Remember that most of the loan portfolio at a typical bank is from loans made 2003 and prior. Dropping interest rates makes all of them more profitable. Oddly, stricter underwriting standards will make it harder to refinance perfoming loans for many borrowers. Unlike 2002, many people won't be able to hop to a new lender for a half a percent difference in interest rates, because their LTV would be too high to refi. The current bank gets to keep the bigger spread longer.



I have a funny feeling it's those kind of calculations taking place in the negotiations of the banks with the fed govt on freezing rate resets.

 

[lawyerliz_IHB]

<p>Excellent, excellent thoughts MalibuRenter. In the why didn't I think of that myself category. I was in a law firm that represented an S & L in mtg closings in the early to mid 80s, where the reverse was occurring. A big low interest portfolio, and huge rates being paid to attract savers. The money was just flowing out.</p>

<p>The bank officers like todays sellers refused to take their lumps and sell the portfolio at a huge discount. They couldn't bear to admit that they had such losses. I and all my closers got fired because we lost the account, because they decided to use their own low cost title company. Naturally it didn't make any difference and they're are long gone.</p>

<p>This is the flip side of that.</p>

<p>A rational explanation of the rewards of delay!</p>