A Bolder Plan

by Bill Apfel, Senior Portfolio Manager and Director of Securities Research

Moral hazard. That’s what economists call it. If you bail out investors or borrowers each time they make a poor choice, sufficient pain won’t be produced to prevent repetition. The system of allocating credit will falter and our market-based economy, which depends on financial incentives both positive and negative, will be damaged. It is a theme you usually hear from lenders who want to make it tougher for borrowers to escape their obligations. Such thinking underpinned the so-called Bankruptcy Reform Act of 2005: Make sure all those profligate credit-card borrowers don’t escape their obligations through an indulgent bankruptcy system.

Well, despite the theory, we are now far into a huge relief program for the lender side of the sub-prime mortgage fiasco. The pain for banks, brokers, and some hedge funds is being addressed by the aggressive actions of the Federal Reserve. Local authorities in New York are seeking ways to shore up the capital of the bond insurers, and foreign investors are pouring capital into our largest financial companies, no doubt confident that government policies will ensure their long term health. A recent proposal floated by Bank of America unashamedly calls for a sweeping program of loan guarantees designed to protect the banking interests. As much as this may make sense for the economy as a whole, it is worth remembering that not much is being heard these days from the lenders about moral hazard.

But what about the other side of the mortgage debacle, the one million–plus households who, through misleading sales tactics or their own shortsightedness, landed in homes priced well beyond their means and well beyond any sensible estimate of value? The numbers are staggering. About $1.2 trillion of sub-prime mortgage debt is outstanding; 15 percent of such borrowers are already behind on their payments, and the ultimate loss, even after the homes backing these loans are sold, might be $400 billion or more. One estimate is that if nothing is done, 750,000 households will have their homes repossessed. While stories abound about upper-income households that took huge loans to buy spacious homes or second homes, the vast majority of those in trouble are lower or middle class, many as a result of illness or job loss. Minority families are affected disproportionately. Must we now apply the moral hazard principal to them?

Of course, in this political year, the rhetoric is all about compassion. And some of the ideas proposed may indeed have merit: Put a moratorium on foreclosures; freeze the teaser rates that enticed so many borrowers; set new, more reasonable fixed rates for existing subprime mortgages; and provide some government guarantees. Already, the quasi government corporations Fannie Mae and Freddie Mac have “temporarily” doubled the size of the new mortgages they will back. Each of these proposals might keep more families in their homes while easing the pain for lenders who may stand to get little from the foreclosure process.

But I believe these proposals are too piecemeal, fail to address the fundamental problems in our housing market, and in some instances may prove more helpful to lenders than borrowers. Importantly, policies that simply delay the day of reckoning for stretched borrowers will not do. Proposals that keep families in their homes but saddle them with mammoth mortgages will only serve to make their predicament permanent. These same policies might also slow the process by which home prices fall to more realistic levels, a requirement for those buyers who aspire to home ownership but have been blocked from the market by high prices.

I would like to propose a bolder plan, but one based on an old idea. Let’s get the government back into the business of guaranteeing reasonable mortgage loans for low- and moderate-income borrowers and let’s do this on a big scale. Does this sound radical? Should this raise the specter of moral hazard? Not by the standards of the not-so-distant past.

In the mid 1950s, inspired by the GI Bill of Rights, more than one-third of all single family home mortgages were directly guaranteed by government programs. I grew up in a home with that sort of mortgage, as did so many of the Baby-Boom generation. By 2006 that proportion had fallen to about five percent, leaving far too much leeway for sub-prime lenders whose mission was to maximize profits, not enable a sensible loan for the biggest financial commitment most people ever make. Ironically, during the past generation, the great transformation in the mortgage industry was led by Fannie Mae and Freddie Mac, which vastly expanded the availability of mortgage credit, but failed to address effectively the needs of lower-income families.

As for all the sub-prime mortgages now in trouble, let the mortgage-servicing companies work out what deals they can for both lender and borrower. As already proposed by a variety of experts, including Secretary of Treasury Henry Paulson, enlightened government policy can encourage reasonable loan restructurings that benefit lenders and borrowers alike. But when an accommodation between lender and borrower only delays the day of reckoning, mortgage defaults may sometimes make the most sense. Critically, such defaults must be excluded from consideration when setting the qualifications for a new government-backed mortgage program. To do otherwise would doom the program to failure. With this provision the process can speed the clearing of the housing market, giving more households the chance to own a home at a reasonable price with a reasonable loan. This approach won’t entail an undue bailout for lenders, and borrowers will sometimes suffer the loss of their home, although they will be given a chance to find a new one. It should, however, take the wind out of the unhealthy credit fuel that made homes just too expensive, too big, and too risky for most Americans.