The Market's Moral Hazard

While most people celebrated the coming of the New Year, many economists have been dreading the day that the current sub-prime mortgage crisis matures into a full-on recession. But while politicians in both major political parties seek to head off what seems to be an inevitable economic downturn with bailout policies and rate freezes, it is not clear that such government intervention is an appropriate remedy for what is essentially mass financial stupidity.

First, a recap may be in order. Just a few years ago, our economy was expanding again in the wake of the dot-com blowout and 9/11 on the strength of a very robust housing market. Houses were being built and sold at record levels, and by 2004, about 69.2% of all Americans owned their own home. One reason for the record spending was due to the Federal Reserve’s slashing of the Federal funds rate to an all-time historical low of 1.00% in 2003, thus making banks more likely to give low-interest loans to people in the market for a house. Another reason for the house buying frenzy was the fact that the values of homes saw double-digit annual gains from the years 2003 to 2006. This appreciation of value was likely due to the massive influx of first-time homeowners into the market responding to the low home interest rates.

All of a sudden, playing the housing game became a way to get rich quickly. As recently as just last year, buying a new house would give you the same rate of return as investing that same amount of money into the stock market (assuming average market returns), or investing three times the price of the house into government bonds (also assuming average returns). Plus, housing has always been a secure investment.

However, this all assumes that a person has the income with which to buy a home. In the world of sub-prime lending, individuals with risky credit histories and low incomes are able to finance the purchase of a house at sub-prime rates, or rates higher than what people with good credit can get when they take out a loan. These higher rates justify the added risk banks and other lenders take on when they loan to high-risk debtors and can work to the advantage of both parties most of the time.

Today, the news is awash with sob stories of families being pushed to the edge of bankruptcy because they decided to purchase a half-million dollar house with a payment plan that takes up half their total monthly income. Sub-prime lending failed because of because of a combination of risky lending practices by creditors and poor financial planning by buyers. In this case, the Fed’s decision to set the funds rate so low gave banks more likely to allow many otherwise ineligible people to buy beyond their means. Many lenders even provided extra incentives to sub-prime homebuyers with low introductory interest rates and promises of even cheaper refinancing plans that buyers could take out in the future. All this contributed to sub-prime lending growing to encompass 20% of all loans made in 2006.

Both last year and this year, many of the low introductory rates that some sub-prime lenders offered to entice clueless buyers will begin, or already have begun, to readjust upwards according to the terms of the loan. Major lenders have already gone under as more and more people who took out sub-prime loans find themselves unable to make the monthly payment. Now, it’s going to get worse. For an industry that drove American growth for the better part of a decade, the bursting of the housing bubble will definitely hurt. Compounding this problem is the fact that sub-prime backed securities seem to be in the portfolios of investors everywhere, and it becomes easy to see why this problem is not going to be easily contained to one sector of the American economy.

But why should this be a bad thing? In an ideal market, good investments are rewarded and bad investments are punished. A recession caused by the sub-prime meltdown is ultimately a self-correcting measure that is necessary to maintain lender, debtor, and investor accountability. Government bailouts of those who engage in reckless financial behavior thus would not only be bad fiscal policy, it could also be considered immoral. On top of however much it would cost to fix the sub-prime problem, the government would also be rewarding bad investment behavior. If the market expects the government to save it from mistakes, then that market becomes a leech and ceases to efficiently allocate resources to the most worthwhile causes. It is clear that the government must avoid the moral hazard and allow for the market correction to run its course.