Friday, February 8, 2008

Moral Hazard

There has been a lot of talk lately about “moral hazard.” Most commonly, I read about the purported moral hazard of the Fed bailing out the Wall Street banks. The conventional wisdom is, that if the Fed bails out the banks, the banks don’t learn anything and continue to engage in lending and investing practices that are risky at best, foolish at worst, and will lead to the need for more Fed bailouts in the future for some as-yet-unknown poorly performing investment.

When people buy homes and borrow the money to buy the home, they sign a promissory note. A promissory note is (or at least used to be) a legally binding contract between the borrower and the lender. The lender, in consideration of the interest it was to receive, promised the borrower to loan the money. The borrower, in turn, promised the lender that it would repay the lender pursuant to the terms and conditions of the promissory note.

In the past few years, lots of borrowers signed promissory notes with ARM’s. In the past three months, various politicians have been on their soap boxes pressuring the lenders to basically forget the written contracts with the borrowers, and freeze mortgage interest rates. At least one presidential candidate is apparently talking about a government mandated freeze on ARM interest rates for 5 years, and a moratorium on foreclosures. In other words, the government is telling the world that those contracts don’t really mean anything anymore.

So if the government is telling everyone that the borrowers’ contracts don’t mean anything any more, is it any wonder that it has become socially acceptable to “walk” on a real estate loan that has lost its appeal in an environment of declining real estate prices?

And if the government actually freezes interest rates on existing ARM’s (in contrast to its “encouraging” investors to freeze interest rates), is that a taking of a private property right requiring the government to pay the investor for the lost of interest? In other words, a government (read: taxpayer) paid bailout of borrowers?

14 comments:

snoop dog said...

We need a debtors prison again.The housing gamblers need to get the balls and pay off the debt they agreed to pay.What a bunch of losers.I would rather be dead than not pay my bills.I am smart enough to know how much I can handle.I have no sympathy for these arm folks who got in over their heads.Their mistakes create opportunity for others.Survival of the fittest!!!!!!!!!!

G Spot1 said...

Forget moral hazard. Freezing rates on ARMs will kill adjustable rate mortgages. ARM rates are low initially because the investors expect at least some of the borrowers to continue paying on a mortgage when the rates adjust. A government rate freeze will basically send a message to the secondary market that they should forget their expectations - we'll make changes to your contracts when we see fit. Why make these deals if they can just be changed later due to political pandering?

For this very reason, a mandated ARM freeze ain't gonna happen. Wall Street and the lenders will never allow it. Even NAR will come to their senses on this one.

I think there are also some serious contract clause concerns that might bar this kind of action, but I have to leave the analysis of that obscure area of Con Law to others.

Sippn said...

I agree with you but want to add.....

Do you think banks and lenders and rating agencies are totally without fault in this? Their practices in general led to the total colapse of the real estate market.

The people who CAN pay their morgage have also been damaged. Many innocent people will loose their jobs because tax revenue is down, business is off, etc.

Jacob said...

I think the loan servicer can make adjustments to the loan to ensure that it keeps getting paid, so they may be able to freeze, I dunno.

But agree that doing that would kill the secondary market and if no investors want to buy the loans then that would be a lot worse.

G Spot1 said...

There is a big distinction between the servicer freezing and the government requiring it. The Bush rate freeze plan was based on servicers voluntarily freezing in order to avoid foreclosure, which as I understand it, they are able to do if foreclosure is likely or imminent, or something like that. Certainly makes sense from a loss-mitigation standpoint.

But the Clinton 5 year freeze plan would be mandatory and far broader in scope.

sacramentia said...

We need more regulation in lending and RE to restore the balance of risk (reduce the moral hazzard). The current system incentivizes people to do exactly what happened. For Example:

- Require buyers to have a minimum 10% so no-one can buy a house with no risk of loss.
- If banks are FDIC insured, require excess profits to be put in a re-insurance fund. This would limit the incentive for Bankers to take on a risk.
- Make mortgage brokers responsible for losses on non-owner occupied defaults up to 150% of the commisions paid.
- Pay realtors a balance of per hour consulting fee and commision so they are not just incented to do deals at any cost.

But nothing like this will probably happen because the boom- bust cycle makes the people at the top of they pyramid very rich.

Patient Renter said...

I'm glad to see you addressing this since many bubble bloggers seem to not understand the completely offensive nature of bailouts and moral hazards.

Moral hazard generally refers to all situations where corporations get to privatize gains and socialize (onto taxpayers) their losses. There is A LOT of this going on with the help of our government, bailouts are just the most obvious way.

"The conventional wisdom is, that if the Fed bails out the banks, the banks don’t learn anything and continue to engage in lending and investing practices that are risky at best, foolish at worst, and will lead to the need for more Fed bailouts in the future for some as-yet-unknown poorly performing investment."

EXACTLY. What have decades of bailouts taught the banks? Nothing, except that when they screw up again, they'll be bailed out again - only the cost imposed on taxpayers is greater each time.

"if the government actually freezes interest rates on existing ARM’s (in contrast to its 'encouraging' investors to freeze interest rates), is that a taking of a private property right requiring the government to pay the investor for the lost of interest"

YES, it is, since the rate freezes could be accomplished through FHA, a taxpayer subsidized entity.

Patient Renter said...

"A government rate freeze will basically send a message to the secondary market that they should forget their expectations"

Only if the government forces the investors to accept the lost interest. BUT, if the government themselves, via the FHA or something else, decides to take on the difference in interest, then the secondary market could care less.

Romney said...

It's beer 30 around here.Time to crack a bud and ponder life as the homeless darelict I have become.Realtors wont even help me find another shopping cart.

Didn't ron paul some up moral hazard fairly well.I cannot beleive how stupid the politicains are that are running this country.I think everyone deserves a million dollars so they can buy a home.

G Spot1 said...

"BUT, if the government themselves, via the FHA or something else, decides to take on the difference in interest, then the secondary market could care less."

Damn. That's pretty much how it's going to happen, isn't it?

Paul said...

Patient Renter and G spot: I think you are both right. Although phrased as providing a "helping hand" to low and medium income households in threat of losing their homes, increasing the conforming loan limits to +$700k and shifting the risk of default to the taxpayers, seems more like it is helping the banks.

Anonymous said...

Not really. I would prefer to have one $650K conforming loan at a reasonable TOTAL rate than a fixed rate up to $419K (or whatever the current max. limit) and then on top of that a jumbo rate with higher interest for the additional $250K.

Why is that helping the banks? I'm still paying for the loan but at a different/reasonable interest rate for the sum total? This assumes that I can afford either scenario but prefer, obviously, the conforming loan amount to $700K?

Paul said...

Anon: My opinion: For a borrower of $650k-700k, new conforming loan limits would appear to be a great deal (although only time will tell. The "rules" and pricing need to be worked out yet, and some pundits have opined that if they are pooled with loans under $417k, the interest rates on the entire pool are likely to be higher due to the greater risk). For the banks currently saddled with billions in jumbo loans on their books, who have been unable to securitize and sell those loans in the secondary market since last August (while the value of many of those loans has declined), who can now sell those loans to Fannie and Freddie, it sounds like an even better deal. For the taxpayers who run the risk of picking up the tab in the event the loans default after Fannie and Freddie buy them, not so much of a good deal.

Patient Renter said...

"Damn. That's pretty much how it's going to happen, isn't it?"

If it's true that history repeats itself, yes we'll have a bailout.