Subprime bailout is not the answer

Sep 4, 2007 @ 12:01 am

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The federal government should step in to bail out homeowners who are in danger of losing their homes because of the subprime-mortgage fiasco through a program such as the Reconstruction Finance Corp., according to Bill Gross, the bond guru at Pimco. That program was started by President Hoover in response to the Great Depression.

“Why is it possible to rescue corrupt [savings and loan] buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 [crisis involving Long-Term Capital Management LP of Greenwich, Conn.], yet throw 2 million homeowners to the wolves in 2007?” Mr. Gross, who is managing director and chief investment officer of Pacific Investment Management Co. LLC in Newport Beach, Calif., wrote in his monthly commentary.

But he misstated the actions of the Resolution Trust Corp., started in 1990 in reaction to the S&L crisis. It did not “rescue corrupt S&L buccaneers.”

It took over the assets and liabilities of bankrupt savings and loans, and sold off the assets to repay the liabilities. A number of the “buccaneers” went to jail — anyone remember Charles Keating?

That aside, providing federal cash to those having trouble paying their mortgages through an RFC would increase the value of securities backed by the mortgages.

The Bush administration and members of Congress are looking for ways to help those who may face foreclosure in the next two years, but most proposals raise several issues.

First, should the government bail out only subprime-mortgage borrowers or all those with floating-rate mortgages who are struggling to meet their monthly payments following rate resets? Why should only subprime-mortgage borrowers be rescued through an infusion of government cash?

Are not those who saved for a down payment but still find themselves in danger of losing their homes equally, or perhaps even more, worthy of assistance?

These people stand to lose their down payments, as well as their homes, while the subprime-mortgage borrowers will lose only their homes (though they might have tax problems.)

But then would the government not be rewarding, or at least making whole, many people who borrowed more than was prudent to buy, more home than they really needed, sometimes as speculative investments?

In other words, would the government not be encouraging moral hazard (i.e., similar bad behavior) in the future?

Second, how would the government identify the estimated 2 million homeowners who may be in danger of losing their homes? The program would be an open invitation to fraud.

Third, there is no easy way for the government to bail out those in danger of losing their homes through foreclosure by providing them with a fiscal bailout without bailing out those who invested in the securities that now hold the mortgages.

Many of these investors bought the securities for their expected high returns knowing that high expected returns suggest high risk. They gambled and lost.

Once again, bailing out those investors would set a precedent that would encourage similar behavior in the future and ultimately lead to another crisis.

If the mortgages still resided at the banks and mortgage banks that originated them, the solution would be easier. The government could lean on those institutions to renegotiate the mortgages.

The lenders would take a haircut and learn to be more prudent in the future. But most of the mortgages have been securitized.

On whom does the government lean? Perhaps it doesn’t have to negotiate. Perhaps the simplest way to help those in danger because their mortgage rates have been reset would be for the government to pass legislation freezing the rates on subprime mortgages at the initial rate for five more years and then limiting increases to 0.25 percentage points for the next five years.

Such a solution would not cost the government a penny. Many homeowners would be able to hold on to their homes until their income increased enough to pay modestly higher rates later, and defaults would decline dramatically.

Best of all, it would inflict a haircut on the unwary buyers of mortgage-backed securities and collateralized debt obligations. They wouldn’t make the mistake again and would demand more transparency of the underlying portfolios.

The government must take actions that deter the kinds of dishonest lending practices that led many prospective homeowners into mortgages they could not afford. That would ensure that a future bubble does not take a similar toll.


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