Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. 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.
This past Monday’s Barrons had a cover story suggesting that $200B would be well spent buying down all subprime mortgages by 25% (total subprime loans are estimated at just over $800B), i.e. simply reducing the principal owed, therefore reducing the payments. Presumably, this would put the mortgage back to a level below the current value of the house in most cases. When I hear such suggestions, I ask myself, “who loses and who gains by this”? It would seems that this idea protects both the bank who will receive a cash infusion as well as the homeowner who got in over his head. The taxpayer will eventually have to pay up, as this is a zero sum game, wealth is not created out of thin air, and even if the treasury simply prints this money, inflation results which devalues our dollar.
Why do we want to save the lenders? It was their own greed that caused them to write mortgages that made no sense at all. The option ARMs were an accident waiting to happen. Why save the homeowners? Many won’t be able to afford even a mortgage reduced by that 25%, and more foreclosures will follow.
I’d like to offer an alternative variation on the above suggestion. We the taxpayers only put up $120B, but the mortgages are all written down by 30%, the banks picking up that other 15%. Now the homeowner has a mortgage only 70% of what it was prior, at a rate that is fixed (5%) and recut to 30 years. But we don’t walk away from our $120B, all homes will carry a first lean equal to the 15% we put up. Money collect on subsequent sale of the property. The banks still get a cash infusion, and only need to write their loans down by 15%, and the homeowner stands a better chance to make those payments, a much lower percent expected to default.