Monday, September 22, 2008

Ounce of Prevention vs. Pound of Cure


The residential-mortgage market failed when millions of homeowners began having difficulty paying their mortgages, thereby imperiling mortgage lenders. That, in turn, imperiled our nation’s financial system because of the lenders’ important place in the system. Financial institutions grew reluctant to do business with one another because they mistrusted each others’ credit worthiness.

As financial markets began to freeze up, the federal government proposed that it borrow $700 billion and use those funds to purchase distressed mortgages from the lenders at prices that would preserve the lenders’ solvency. The federal government – already operating in a deficit – would go deeper in debt in order to purchase mortgages from lenders who could no longer collect on the debts owed them.

What an irony that an administration whose free-market ideology abhorred regulation and warned against moral hazard has now brought on the greatest moral hazard in our nation’s history by turning its back on the very regulation that could have prevented the mortgage-market’s failure.

Federal regulators warned the Bush administration that lenders were encouraging borrowers to take on excess debt on terms they could not afford. But the administration turned a deaf ear and hoped that rising real-estate values would save everyone harmless.

When defaults and foreclosures began to rise, the administration invoked the doctrine of moral hazard and said it did not wish to encourage risky behavior by assisting those that had borrowed recklessly. When financial institutions began to fail, the administration was forced to assist some but refused to help all.

Finally, when the entire financial system verged on dysfunction, the administration came forward with its rescue plan. Since the administration refused to provide the ounce of prevention, we now await the efficacy of the pound of cure.

© 2008 Michael B. Lehmann

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