Tuesday, May 6, 2008

Put Taxpayer-financed Mortgage Bailouts in Borrower Credit Histories

(In the spirit of “Humpty Dumpty”):

The mortgage market was having a ball,

When all of a sudden, it took a great fall.

All the Street’s bankers and a chairman named Ben

Couldn’t put the market together again.

Today, May 6, 2008, Chairman Ben Bernanke of the Federal Reserve again urged lenders and mortgage loan servicers to reduce the amounts owed on underwater mortgages to the reduced value of the property. In other words, if the value of the property has fallen below the amount of the mortgage debt, the lender or loan servicer should simply swallow the price drop as a loss. The Bush administration is trying to increase the role of the FHA, Fannie Mae and Freddie Mac in refinancing distressed homeowners. John McCain, the presumptive Republican nominee, makes proposals that are largely similar to Chairman Bernanke's and the Bush administration's ideas. The two Democrats vying for the presidential nomination, Barack Obama and Hillary Clinton, make more expansive proposals for federal assistance to distressed homeowners.

What will actually happen depends a lot on who wins the election this November. But we would make one suggestion that should apply regardless of who becomes the next President: all mortgage borrowers who receive taxpayer financed assistance should have an asterisk inserted in their credit histories.

One of the primary arguments against government bailouts of distressed homeowners is that those who were reckless and imprudent, or maybe even deceptive or fraudulent, benefit at the expense of those who were scrupulous and honest. Economists call this problem "moral hazard." It rewards people for taking undue risks and behaving in undesired ways, which only leads them to engage in more undesirable conduct in the future. The costs of their misbehavior, on the other hand, are borne by innocent bystanders.

What makes the current mortgage crisis so problematic is that the losses are astronomical--certainly hundreds of billions, and perhaps more than a trillion, dollars. Last time we checked, that's still a fairly large number. A game of musical chairs is now progress, with borrowers, bankers, investors, loan originators, loan servicers and, unfortunately, taxpayers all maneuvering to see who has to bear those losses. With the amounts involved so large, all the private sector players are doing the expedient thing and turning to the federal government with their hands held out. Given the political pressure, taxpayer-funded assistance of one sort or another is inevitable. We will surely end up with billions of dollars of moral hazard in the mortgage markets.

But to slightly reduce the free ride effect that a federal bailout would create, the government should insist that all federal refinancings be specifically noted in the borrower's credit history. Without federal assistance, the borrower would almost surely have defaulted and had black marks placed on his or her credit history (as well as probably lost his or her home). Recording the fact of a federal bailout will tell future lenders that this borrower may not be a sterling customer. In this way, those borrowers who were reckless, imprudent, or worse, may bear some future consequences. They might have a harder time getting loans (and rightly so). When the taxpayer is saving these borrowers their homes, it's only fair to create a disincentive for the borrowers ever again to be a public burden.

Some borrowers have sad stories to tell about how they were pressured and deceived by unscrupulous lenders into signing up for astoundingly one-sided and unfair loans. And we hope the mortgage originators and lenders in these cases are sued, found liable, and better yet, convicted and imprisoned for long periods of time where they can contemplate their crimes as they break up many rocks. But borrowers have moral responsibility, at a minimum, to know and understand the terms of their loans; and they have no right to a taxpayer-financed bailout. Banks have been booking billions of dollars of losses, mortgage firms have been going into bankruptcy, many financial services employees have lost their jobs (including a few CEOs) and more will probably lose theirs. Thus, many of the participants in this morass have suffered adverse consequences for the mistakes that were made. Borrowers who take a handout from the taxpayers should also have to live with at least some consequences of their behavior.

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