Thursday, March 6, 2008

Smoking In Bed and Fiddling While Rome Burns

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Suppose somebody sets his or her home on fire while smoking in bed. Should the fire department turn around and say, “Sorry, we’re not rescuing anyone dumb as you. Smoke in bed…….pay the price. We’re heading back to the station house. Deal with it on your own.”

No doubt some of us would feel that way. Besides, what better way to teach a lesson to all the other morons out there. If they see the first bozo’s house go up in flames, that may teach them a lesson about (not) smoking in bed.

From thoughts such as these stems the notion of “moral hazard.” Assist those who indulge in foolish risk, and risky behavior is abetted. Let the perpetrators suffer the consequences, and risky behavior is prevented.

Sounds simple. But no fire department asks, “How did the fire start?” before it quenches the flames, let alone rescues the victims. There are a number of reasons for this, but one of them certainly is that no one wants the entire neighborhood to burn down. The surest way to prevent the neighborhood’s destruction is to save the smoker’s house. The collective good is more important than teaching the dummies a lesson.

And that brings us to the mortgage crisis. Some have said that a bailout creates a moral hazard by rewarding speculators. Better to let the lenders foreclose on these properties than to save foolish borrowers from their own stupidity. But others have pointed out that wholesale foreclosures put additional downward pressure on home prices as lenders dump foreclosed properties on the market for whatever they may bring. That just leads to a cascade of additional foreclosures on properties abandoned because their value has fallen below that of the mortgage. Far better – from the collective point of view - to save the loan and the borrower, and keep the property off the market and thereby prevent property prices from falling further. Don’t fiddle by moralizing while Rome burns.

Recent news accounts indicate that we may be moving away from the individual culpability and moral-hazard perspective to a broader consideration based on society’s benefit. For instance, only two days ago, a March 4 New York Times article (http://www.nytimes.com/2008/03/04/business/04paulson.html?_r=1&oref=slogin) carried the headline “Relief for Homeowners Is Given to a Relative Few” and the subheading said, “Some analysts predict foreclosures will end up in the millions.” The article reported, “But while the data showed an increase in forbearance, it also showed that only a tiny fraction of troubled borrowers are getting either a reduction in their interest rate or in their loan amount,” and “…industry executives acknowledged that many and perhaps most of the loan modifications so far simply stretched out the original repayment terms.” Moreover, Secretary of the Treasury Henry Paulson “…reiterated his opposition to proposals for a government bailout of subprime borrowers, which would also bail out many lenders.” That’s the moral-hazard perspective.

But just a day later (yesterday), on March 5, the Times (http://www.nytimes.com/2008/03/05/business/05housing.html) headline read, “Bush and Fed Step Toward a Mortgage Rescue.” The lead paragraph said, “However much they might oppose it on ideological grounds, the Bush administration and the Federal Reserve are inching closer toward a government rescue of distressed homeowners and mortgage lenders.” The article went on to report that. “Representative Barney Frank, chairman of the House Financial Services Committee….proposed legislation last week to allow the F.H.A. to insure up to $20 billion in troubled mortgages if the lenders first agree to forgive a big part of the original loan amounts.”

Perhaps the powers-that-be won’t let Rome burn in order to prevent moral hazard.

© 2008 Michael B. Lehmann

1 comment:

dblwyo said...

Mike - a good point we can hope.Let me complement it with two other considerations: moral justice & political support and workability. Given that we need a workout program it would need to be massive and well-administered as well as quick. Various sources, e.g. CalculatedRisk indicate that the appropriate level of skilled resources are NOT available. This "rescue" will be more massive than the S&L bailout and could/should be a major national program.
Which will required serious support and resources (have you seen Feldstein's WSJ ed. ? A start IMHO). Given that this whole thing was greed run amok driven by perverse incentives on everyone's part support will be limited if that pain is not appropriately spread. And this is not an ideological but a pragmatic position. That means people who bought what they shouldn't have need to suffer appropriate but the mortgage originators who substituted deal flow, chicanery and malfeasance for good analysis and business practice are more culpable in my book. One could then work one's way up the ladder of synthetic debt engineers and financial institutions. Consider this a failure of institutional design and incentive mechanisms. If we'd simply match negative bonuses to prior year's positive ones it seems to me that rough justice would exist AND we'd improve all of these structurally broken factors.