Moral hazard is central issue in housing bust (redux)

Many issues compete for our attention in the wake of the housing bust. However, the importance of these issues is not equal. Underlying most of them is the central problem of the housing bust: moral hazard.

Every decision we make in life has consequences. If we save regularly and invest wisely, the consequences are wealth and peace of mind. If we spend foolishly and speculate wildly, the consequences are periods of feast and famine, delusions of grandeur, enormous entitlements, and when times are tough, unbearable stress. Positive results come from good decisions and visa versa. That’s how people distinguish wise from unwise and learn to make decisions to achieve positive and desirable ends. When people do not endure the negative consequences for their poor decisions, they come to regard their poor decisions as wise ones, and they repeat the same mistakes.

Families dealing with alcohol or drug abuse are well acquainted with the dilemma of moral hazard. If a sibling or child goes on a bender and ends up in jail or the hospital, most people will go bail them out. People can learn from both success and failure, and waking up in jail or in a pile of your own puke can be very instructive. The first time or two this happens, it is appropriate to help out a friend or family member. However, on the fifth, tenth, or hundredth occurrence, the person is not learning the lesson, and continuing to soften the consequences simply enables and encourages more bad behavior. This is the essence of moral hazard. Unfortunately, it’s not a black-or-white right-or-wrong issue. It is at the extremes, but the grey in the middle can be difficult to sort out. How many times would you bail out a loved one before you stopped?

Let’s take a typical example from the housing bubble. Many people run up $10,000 to $15,000 per year in credit card debt because they are fiscally irresponsible and fail to live within their means. During the bubble, loan owners would go to the housing ATM machine, pull out a year’s worth of irresponsible spending, and pay off their credit card debt. After two or three years of this, they come to rely on this yearly cash infusion. Rather than seeing their annual $10,000 to $15,000 spending as irresponsible, they see their house as another breadwinner, and the yearly ATM visit becomes an entitlement. The connection is lost between the foolish action — spending their home equity on consumer goods — and the consequences of their actions — being broke and losing their homes. The ability to freely access and spend home equity creates moral hazard.

The policies and bailouts our government crafted to deal with the collapse of house prices create additional moral hazard. Bailouts by their nature create moral hazard. The purpose of a bailout is to prevent an individual or family from enduring the consequences of their bad decisions. It simply is not possible to have a bailout without moral hazard, it’s only a matter of degree.

Loan modifications create moral hazard because borrowers know they can overborrow and obtain relief. Principal reduction creates the extreme of moral hazard because it actually encourages irresponsible borrowing to get free money. The worse the situation of the debtor, the more likely they are to receive free money through principal reduction. Look at the incentives these policies create. If borrowers are prudent and keep their debts manageable, they get no relief. If borrowers take on too much debt, they are given payment relief through a loan modification. And if borrowers go completely overboard and take on more debt than they can possibly handle, they are given debt relief through principal reduction. Worse yet, those who do not take on debt get to pay the bills either through taxpayer-funded bailouts or reduced savings returns as the federal reserve lowers interest rates to divert money to weakened banks. The incentive is to maximize debt. If the debt relief carries consequences of poor credit and limited access to credit in the future, then consequences match the mistake. However, if the consequences are minor or entirely circumvented, then moral hazard is sure to result.

(watch this video if you have the time. It’s great)

When confronted with the problem of moral hazard, its easy for people to dismiss it as a problem for philosophers and poets. Who cares if a few loan owners get a free ride? Well, would any of you write a loan owner a personal check to give them money for taking on a loan they could not afford? That’s what you’re doing. If the GSEs or the FHA begin reducing principal, the US taxpayer is covering the bill. Sure, you didn’t write the check directly to the loan owner, but you might as well have. If you give money to the government who gives it to the GSEs or the FHA who gives it to a loan owner, the government is merely a conduit diverting your hard-earned money to loan owners. When the federal reserve lowered interest rates to zero on your bank savings, the interest that used to be yours was instead diverted to insolvent banks to shore up their balance sheets. Again, you didn’t give money directly to the bank, but you might as well have. The interest money that should have been yours went to covering the losses on the free money given to loan owners. How do you feel about these subsidies you are providing?

The people who sacrificed and saved get rather upset when their money is given to those who were irresponsible. Ask the Germans how good they feel giving billions of dollars to the Greeks. The Germans work hard, take very little time off, and save prodigiously. The Greeks party hard, have some of the longest vacations in Europe, and spend prodigiously. The Germans don’t mind lending the Greeks money to earn a return, but giving it away is a different story. And it should be.

The same is true of the tension between savers and spenders in the US economy. Savers sacrifice current consumption to earn a return and enjoy greater consumption in the future or to acquire wealth. Spenders maximize current consumption and hope future austerity never comes. When producers and savers are punished with onerous taxes and low returns on safe investments, they lose their incentive to produce and save. Without producers and savers, what would spenders consume?

When policy makers worship spenders as the backbone of our economy, they completely miss the point. Economic growth comes from production and savings, not consumption. Our policies now encourage spending and discourage saving. While this may maintain some illusion of growth in the short term, it hurts our economy in the long haul. Here we are five years after the housing bust, and although we are officially out of recession, does the economy feel robust to you? I don’t feel it, and neither do most Americans.

The moral hazards in our system of housing finance are out of control. In years gone by, people used to get home loans to acquire an asset that would otherwise take a lifetime of savings. People would borrow money and diligently work to pay it off. The value of their home became a store of wealth. With an abundance of home equity and decreasing debts, the housing finance system was very stable. With the financial innovations of the housing bubble, lenders created an entire generation of Ponzis who see nothing wrong with borrowing and spending home equity. This completely destabilizes housing markets. Houses become valued based on their capacity to generate HELOC money. The more prized they are, the faster then go up in value, and the more HELOC money they provide. The Ponzi scheme goes as far as lenders allow it. Now with backing of the US taxpayer, lenders have little incentive to lend prudently. Perhaps Dodd-Frank with its requirement for lenders to hold 5% of non-qualified loans on their books provide some risk of loss, but how long will it take for lenders to cover that risk with credit default swaps? Not very long I imagine.

Transferring wealth does not stimulate the economy

If the people getting the assistance spend money on goods and services and stimulate the economy, do I benefit from that? Well, I could have spent that money myself to stimulate the economy, so taking it from me and giving it to someone else has no net effect on the economy I benefit from. However, it does reduce my consumption and quality of life which impacts me negatively. Those of us paying the bills and getting none of the rewards do not benefit from these bailouts in any way.

Moral hazard is not just another issue raised by the collapse of the housing bubble. Moral hazard is the core issue underlying every possible “solution.” The correct course of action is to allow failures to fail and endure the consequences of their poor decisions. These houses should be recycled through foreclosure and put into hands of stable borrowers at price points they can afford with loan terms that are stable. Getting from here to there will be painful to lenders and loan owners, but that is their problem. I didn’t make the mistakes they did, and I don’t want to endure the consequences with them or for them.

Your tax dollars at work

Today’s featured property is now owned by Fannie Mae. The losses Fannie Mae will absorb on this property will be paid by you as a US taxpayer. The property was purchased for $164,000 back in 1996. By 2008, the owners had increased their mortgage to $375,000. While you were working, paying your bills, paying your rent or mortgage, these people were taking over $200,000 out of your wallet and spending it. Whatever they spent that money on you paid for.

If any of you feel good about giving money to complete strangers so they can have fun, please PayPal me some money. I promise to blow it, stimulate the economy, and have a good time. Further, in the spirit of being a true Ponzi, I will not to write about it on the blog. I wouldn’t want anything productive to come from it. That wouldn’t be right.

What did these people learn?

The former owners of today’s featured property used the appreciation of their property as supplemental income. In other words, they were Ponzis. The learned they could consistently go to the bank and make withdrawals of equity, and when they couldn’t afford their new mortgage payment, the bank was going to let them squat for years. This is moral hazard in action. If we let these people buy a house again, what do you think their expectation is?

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521 West ALTON Ave #29 Santa Ana, CA 92707

$339,900 …….. Asking Price
$150,000 ………. Purchase Price
9/30/1999 ………. Purchase Date

$189,900 ………. Gross Gain (Loss)
($27,192) ………… Commissions and Costs at 8%
$162,708 ………. Net Gain (Loss)
126.6% ………. Gross Percent Change
108.5% ………. Net Percent Change
5.9% ………… Annual Appreciation

Cost of Home Ownership
$339,900 …….. Asking Price
$11,897 ………… 3.5% Down FHA Financing
4.47% …………. Mortgage Interest Rate
30 ……………… Number of Years
$328,004 …….. Mortgage
$101,245 ………. Income Requirement

$1,656 ………… Monthly Mortgage Payment
$295 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$71 ………… Homeowners Insurance at 0.25%
$369 ………… Private Mortgage Insurance
$225 ………… Homeowners Association Fees
$2,616 ………. Monthly Cash Outlays

($333) ………. Tax Savings
($434) ………. Principal Amortization
$20 ………….. Opportunity Cost of Down Payment
$62 ………….. Maintenance and Replacement Reserves
$1,930 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$4,899 ………… Furnishing and Move-In Costs at 1% + $1,500
$4,899 ………… Closing Costs at 1% + $1,500
$3,280 ………… Interest Points at 1%
$11,897 ………… Down Payment
$24,975 ………. Total Cash Costs
$29,500 ………. Emergency Cash Reserves
$54,475 ………. Total Savings Needed
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