When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 3of3)
In the first two parts of this series I discussed two of the leading programs currently being considered to solve the home mortgage crisis in America. In this final installment I would like to address a widely ignored issue, the moral hazard these policies create by providing publicly funded safety nets for risky practices. I do not contest that something needs to be done to protect our financial institutions, however I do believe it should be considering when deciding which is the best rescue policy.
Circling back to a discussion I started in “Truly understanding the credit crisis, and why this isn’t really all Alan Greenspans’s fault” I think it is important to examine the risk structure these policies are creating. The lending side of this crisis was fueled by an incentive structure that put risk onto public entities while the benefits were held by private banks. Both proposals presented in this series make this incentive structure worse by moving more risk from banks to the Government, thereby creating a moral hazard which encourages risky behavior. Given the situation we are in we may be left with choosing the better of two evils for the sake of saving our country’s financial market, but it is worth an exercise to examine both proposals through this lens.
A loan guarantee is a strong moral hazard for both the lender and the borrower. In this case the borrower is rewarded by receiving a government backing for real estate they cannot (and never could) really afford and the lender receives an unwarranted guarantee for lending to risky borrowers. It is easy to see the moral hazard here. If the bank is able to lend to risky borrowers in good times, and then receive government backing for these loans in bad, what becomes of the risk adverse incentive to have strict underwriting requirements? I also outlined in my first installment of this series how this program creates an extra reward for banks if they foreclose, possibly creating more of an incentive to foreclose. This program creates a win win deal for banks (win if they continue poor underwriting practices, and win if their bets go wrong and have to foreclose) who made poor decisions. The guarantee program has not included any discussion about adding cost to banks or troubled home owners to make the government option a last resort, and a guarantee inherently does not have the flexibility to punish lenders for making the risky loan in the first place. Of all options this one seems to have the worst long term consequences.
A program similar to the HOLC also has some moral hazard issues, but can be designed to “punish” borrowers, and to some extend lenders, for their risks. As I noted in part 2 extending the term of mortgages are a key part of this policy. As such borrowers will need to maintain their entire debt service. A borrower will not be rewarded for taking the risk of an unsustainable home purchase price. If I were designing this policy I would also recommend adding some additional costs onto the troubled buyer. These costs should be high enough to prevent performing mortgage holders from abandoning their private loan because the government program is more favorable. These costs can best be added through deed restrictions, which could prevent a homeowner from selling their property for a certain time period. It is similar to the way New York City (and possibly other cities) prevent recipients of below market housing to profit by quickly flipping their property. The policy will keep troubled borrowers in their homes, punish them for risky decisions, and make the government program a last resort instead of a first. For banks the story is not as easy. A cost can be added by purchasing the mortgage at "bargain prices" essentially paying some discount from the principle+amortized value of the loan. This will further help the government to reissue the loan at a lower interest rate. But this punishment should not be so great that the bank is better off foreclosing. It will have to be a delicate balancing act but at least the flexibility exists.
Hopefully Alan Greenspan was right when he last spoke to Congress saying this is a “once in a century event.” If true, the Government will not be constantly needed to keep our financial markets healthy. It is difficult to think of a perfect policy where a Moral Hazard could be completely avoided, after the $700 Billion bailout bill was past the damage was already done. We can however try to prevent the next crisis. Any government bail out program must come with some innovative, yet flexible, new regulation. I think the bulk of this new regulation will be left to our next President (the Republican's do not want to touch that) so I wait with baited breath to see what President Obama will be coming up with.
 With all discussion about how bad government guarantees are, I thought it appropriate to describe a situation where it works. The government can solve a market failure with a guarantee. Micro loans (average of $10,000) are a great example. These loans are too costly to issue for banks because they are risky and provide low return, but are vital for micro-business (1-15 employees). A guarantee on these loans make them more cost efficient because they lower the risk, giving micro-business access to much needed credit and banks a cost savings inducing them to lend. Note these are always for new loans and do not address businesses that are over leveraged.
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