Friday, December 07, 2007

More on the Subprime Bailout: Moral Hazard

New York Sun: Wall Street critics are coming out in force against President Bush's proposal to prevent subprime mortgage lenders from foreclosing on some homes.

Chief among the complaints is the notion of moral hazard — that borrowers who voluntarily took on too much risk are now being rewarded for their bet.

Let's review moral hazard:

Moral hazard is the prospect that a party insulated from risk may behave differently than it would if it were fully exposed to the risk. For example, an insured party's behaviour might be more risky than it would have been without the insurance. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.

Moral hazard can also occur with borrowers. Borrowers may not act prudently when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.

Bottom Line: Because of moral hazard alone, the subprime bailout is a BAD idea.

11 Comments:

At 12/07/2007 1:22 PM, Blogger Walt G. said...

Isn’t this somewhat like rewarding my neighbor for buying a losing lottery ticket by changing it to a winning ticket while I saved my money by not gambling, and then taxing me to pay for his lottery ticket winnings? Somebody has to pay for risk. Why shouldn’t it be the risk taker?

 
At 12/07/2007 4:59 PM, Anonymous Anonymous said...

Walt G. said...

...Somebody has to pay for risk. Why shouldn’t it be the risk taker?


Do you mean the inexperienced, uninformed borrower or the professional, expert, knowledgeable lender?

 
At 12/07/2007 6:07 PM, Blogger juandos said...

"Do you mean the inexperienced, uninformed borrower or the professional, expert, knowledgeable lender?"

Does it matter?

The person signing the contract was an adult and has all the responsibilities of an adult...

BTW where are the feelings of pity for the people who has part of his/her portfolio in his/her 401k or IRA in a corporation that lent money to people incapable of paying what they signed on for?

We hear plenty of it in the MSM for people who made bad decisions with regards to the house they attempted to purchase...

 
At 12/07/2007 6:37 PM, Anonymous Anonymous said...

Two factors: 1) The risk takers are voters.

2) This isn't really going to help them as much as it helps Wall Street.

 
At 12/08/2007 4:20 PM, Blogger juandos said...

anon @ 6:37 PM makes to very valid points...

Good ones!

 
At 12/09/2007 2:43 AM, Anonymous Anonymous said...

The bail out is going to create havoc.

Look at it this way...if your neighbor who has a credit score 10 points lower than yours gets to keep his low interest rate while your rate resets and your payments put you in the poor house there isn't much you can do or say about it all by yourself.

Now think about what is going to happen with tens or hundreds of thousands of cases like this. It's going to be pandemonium.

 
At 12/09/2007 8:59 AM, Blogger easymoney said...

anon 4:59:

Apparently, you believe most of the subprime borrowers are dupes.

In that case, they should be kept out of the mortgage market all together - and for that matter, all other forms of consumer credit.

Oh wait, politicians would then accuse them of red lining.

It's great that people like you always get to claim "heads I win, tails you lose."

 
At 12/09/2007 11:35 AM, Anonymous Anonymous said...

easymoney said...

anon 4:59:

Apparently, you believe most of the subprime borrowers are dupes.


Evidently you did not see the question mark at the end of my sentence.

I merely wished to draw attention to the lenders, that for a period were handing out money without requiring any evidence what-so-ever that the borrower was capable of paying the loan back.

Lenders suspended their common sense and ignored such time honored practices as verifying income and relied upon the borrower to tell them, in good faith, what they were supposedly earning. A more fertile ground for fraud hasn't been sown in recent memory.

The lenders knew that they were heading down a path to failure with subprime loans.

I know this because I talked to many lenders on a daily basis for years and the topic of conversation nearly always included the coming mortgage meltdown we are in the early stages of right now.

So who is at fault the lender that knew better because of their education, professionalism and training (in behavioral economics and fraud prevention, etc.) or the people that took out these loans. Who amongst those borrowers would have borrowed had they been aware of the risks of their actions?

You'll notice that I haven't come up with a solution to the problem just pointed out some other things to consider besides blaming the borrower.

The borrowers aren't going to clean up this mess. Someone is going to pay for it and it isn't going to be the borrowers or the lenders.

 
At 12/09/2007 6:32 PM, Blogger Walt G. said...

If people are allowed to assume risk without paying for it, where’s the disincentive? Why don’t you send me some money through paypal so I can buy some lottery tickets?

anon 11:35
"Someone is going to pay for it and it isn't going to be the borrowers or the lenders."

Isn't everyone pretty much a borrower, a lender, or both?

 
At 12/09/2007 11:51 PM, Anonymous Anonymous said...

"Are borrowers aware of the terms and conditions of their loans, and more generally, are consumers sufficiently well-informed to be wary of potentially misleading marketing tactics and to shop effectively among lenders?"

--Ben Bernanke, Federal Reserve Chairman

 
At 12/10/2007 3:15 AM, Blogger easymoney said...

There are many people who are not borrowers: Their house is paid for and they pay cash for everything.

Certainly the ONLY ones who should pay are the borrowers and the lenders: the parties to the contract. Let the parties to the contract resolve their differences.

The ONLY ones who SHOULD NOT pay are the taxpayers.

This is another example of the creeping involvement of government in our everyday lives.

The government is going to solve:

1. Health care
2. Retirement
3. and now housing.

Is there anything the government won't/shouldn't provide us?

So it would seem advisable that:

1. Lenders should return to more prudent forms of lending. They should charge the no-documentation and low-credit score borrowers the corresponding high interest rates right from the beginning.

2. Politicians should stop threatening banks with fines and penalties when the banks won't lend to sub-prime borrowers at prime rates or if banks decide to avoid the sub-prime market altogether.

3. Though not likely, Congress itself needs to be subject to whatever "solution" it comes up with. All legislation should be subject to a cost/benefit analysis and these should be plainly spelled out to the taxpayers.

The ironic part is that politicians who

1. Don't read much of the legislation they sign,

2. Can't pass a bill that is easily understood by the average citizen,

3. Can't pass a bill that they fully understand,

4. Can't balance their own budget,

5. and spend more money than they have

are going to lecture the banks on how to run their business?

 

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