Wednesday, September 10, 2008

Alternative Scenario


Suppose your local fire department sold cigarettes, but refused to fight fires caused by smoking in bed. When fire fighters arrived at the blazing home of a bedtime smoker, they returned to the firehouse without extinguishing the blaze. Their rationale: Avoid moral hazard. Don’t reward bad behavior. Their reasoning: We sell cigarettes. We don’t tell people to smoke in bed.

You can imagine your neighbors’ reaction as the blaze leaped from structure to structure and the entire block went up in smoke. The fire fighters might say, “We don’t want to encourage smoking in bed, so we won’t fight those fires.” Your neighbors would say, “Extinguish the blaze now. Make the moral case later.”

This fable reminds us of the federal government’s handling of the housing debacle. Federal authorities initiated the real-estate boom by depressing mortgage interest rates. Private lenders exacerbated matters with their risky lending practices. Home prices soared. Then, when the boom went bust and home prices began to collapse, the federal government declined to come to the rescue of borrowers and lenders that the authorities deemed unworthy. The authorities invoked the doctrine of moral hazard, saying they did not want to use taxpayers’ money to reward bad behavior. “No bailouts” became a rallying cry. Assistance went to those borrowers least likely to lose their homes. Care was taken to punish the stockholders of distressed financial institutions.

But where has this moralizing left us? We have lurched from one crisis to another, and still there is no end in sight. Hundreds of thousands of houses are in foreclosure, and the number grows daily. Abandoned dwellings blight neighborhoods, depressing the value of nearby structures. Home prices continue to fall, tempting ever-larger numbers of owners to walk away and leave their unpaid mortgages in the bank’s hands. Financial institutions, from Bear Stearns to Fannie Mae, collapse or are placed in jeopardy. The US Treasury and Federal Reserve devise rescues, only to have them prove inadequate as matters worsen.

There is no doubt that home prices had to fall, destroying billions of dollars of real-estate value. That’s what happens when bubbles burst. Suppose, however, that the federal government had moved early and aggressively to assist almost all borrowers and lenders facing foreclosure. Assistance could have been restricted to homeowners living in primary residences, thereby excluding speculators, multiple-home owners and vacation-home owners. A way could have been found – such as a means test – to exclude those who falsely claimed inability to pay. Distressed mortgages could then have been written down to affordable levels and the federal government could have saved lenders harmless by paying lenders the difference between the loan’s original high value and the loan’s new low value.

This would have stopped the runaway foreclosures and permitted homeowners to remain in their homes. There would have been fewer abandoned and blighted buildings and fewer ravaged neighborhoods. That would have reduced the downward pressure on home prices and eased the stress in financial markets. Most importantly, homeowners would have been spared the tragedy of home loss.

But what about the moral hazard? It is true that, had the above plan been implemented, some of the undeserving would have been helped along with the deserving. So what? The federal government’s economic-stimulus package paid out tax rebates to almost every one. Why were those folks more deserving than the homeowners? If we are so concerned about taxpayers, why have we run massive deficits? Besides, collapsing residential real-estate markets were ground zero for the current economic crisis. We could have focused relief on these immediate victims rather than spread the payout to those unaffected by the real-estate collapse.

The housing debacle could have been alleviated early on with a massive federal program directed toward mortgage holders and lenders. The firefighters could have saved many homes from the conflagration. Instead, the federal government dithered and raised concerns about moral hazard. This permitted an unfolding crisis to turn from bad to worse.

© 2008 Michael B. Lehmann

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