We Avoided Moral Hazard, And Now Rome Burns

THE BE YOUR OWN ECONOMIST ® BLOG

Today’s near-collapse of Fannie Mae and Freddie Mac, and the accompanying erosion of stock-market values, can not be blamed on the managements of those firms. To a large extent they, and the markets generally, have suffered because of our commitment to avoiding moral hazard.

We want home buyers and lenders to suffer the consequences of their actions. No bailouts!!! They borrowed (or loaned) too much and paid (or loaned) too much. It’s their problem. If millions of homes consequently go into foreclosure and drag down everyone else’s property values, so be it. Market discipline! That’s what’s needed to wring the excesses from the system today and prevent speculation tomorrow.

It’s a fire-and-brimstone sermon. It avoids moral hazard. But the consequent debacle will burn the innocent with the guilty.

Suppose, instead, the federal government had bailed out borrowers and lenders by purchasing mortgages headed for default. The mortgages’ value could have been written down to a level that home buyers could afford, with the federal government paying the lender the difference between the old high value and the new low value. The result: Home buyers remain in their homes and make affordable payments while lenders are saved harmless and need not write down the mortgage values. The rash of foreclosures would have been dramatically reduced and the collapse in home prices contained.

The federal government, of course, would have to finance the bailout by deficit spending. But that’s exactly how the current economic stimulus plan works. The government borrows more in order to mail rebates to income-tax payers. Wouldn’t it be better, instead, to target that effort toward the real-estate market that comprises ground zero for our present problems? Why pay out money to all in the hope their purchases will stimulate demand, when we could target those funds to alleviate the real-estate crisis that is the root cause of our difficulties?

Only our moralizing stood in the way.

© 2008 Michael B. Lehmann