Business Times - 15 Dec 2007
US sub-prime bailout creates a moral hazard
Proposed rate freeze may drag out recession, responsible mortgagees will have to compete for benefits and tax breaks
By LEON HADAR
'HELP is on the way!' is the kind of slogan that should probably be embraced by every US politician ranging from the Republican White House to the Democratic-controlled Congress - all of whom seem to agree that the federal government needs to come with a 'relief plan' to help consumers and businesses devastated by the ups and downs of the economy.
Indeed, notwithstanding the ideological differences between the free marketers who supposedly dominate the Republican party and the more social-democratic-oriented Democrats, the fact is that both parties share the view that the government needs to 'do something' to deal with the current sub-prime crisis.
While Democratic lawmakers, presidential candidates and liberal pundits have criticised some elements of the Bush Administration's foreclosure relief plan that allegedly aims to help around two million distressed homeowners, they have been promoting their own mortgage bailout plans.
That is not surprising when one takes into consideration that the states that are going to become a central electoral battleground in the coming presidential elections - Florida, for example - also happen to the states whose residents have been the most effected by the repercussions of the sub-prime mess. Pandering to voters does work.
US President George W Bush and Treasury Secretary Henry Paulson have stressed that their plan would streamline the mortgage modification process for distressed borrowers, offering 'more relief to more homeowners, more quickly', as the president put it, by allowing borrowers to refinance existing mortgages at a lower rate or into a mortgage guaranteed by the government.
More specifically, the relief plan includes a five-year freeze on interest rates for borrowers who are current with their monthly payments and with adjustable rate mortgages (ARMs) resetting beginning in 2008. Based on criteria which seem to exclude several groups of borrowers, it's not clear how many borrowers would actually be covered by the 'freeze'. Estimates range from 150,000 to 350,000 sub-prime borrowers with ARMs expected to be reset through to the end of 2009. Excluded are borrowers judged capable of continuing to make mortgage payments at the higher reset rates.
The plan isn't going to bail out all - or even most of the sub-prime borrowers - since less than half of all sub-prime mortgage rates are fixed-rate loans (while less than a third of all ARMs are sub-prime). According to The New York Times, from mid-2007 to now, some 800,000 borrowers have entered foreclosure. From 2008 through mid-2010, economists expect an estimated 3.5 million home loan defaults.
That suggests that the bailout plan won't help most of those who are going to be affected by the housing crisis - raising major doubts about the fairness of the plan.
And while the plan may help to streamline the modification process, it would not deal with the main continuing threat posed to the economy: the process through which these loans were restructured and resold to investors.
It's the impact of this securitisation process that has yet to seep through the structure of the entire financial system as the number of delinquencies and foreclosures increase and investors calculate their overall losses.
Hence the concern that short-term steps like the proposed bailout wouldn't be able to contain a coming recession driven by the long-term credit squeeze and financial imbalances exacerbated by the US dollar decline.
In fact, the proposed rate freezes could end up dragging out the recession by delaying new home construction, among other things.
Moreover, the bailout plan raises once again an issue of moral hazard - bailing out those who engage in risky financial behaviour encourages them to repeat that same risky conduct in the future - that should certainly be of concern to the free marketers of the Bush Administration.
The plan also sends the wrong message to responsible homeowners who are current on their mortgages and who would have to pay more taxes to help finance those who acted irresponsibly. Indeed, responsible mortgagees will have to compete with those getting bailout benefits and tax breaks.
At the same time, the precedent of revising private contracts through government action, instead of allowing the sides to renegotiate their agreements, will surely create pressure for similar action if the economy does face a recession.
Whatever happened to free marketers' faith in the system?
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