Weathering the subprime crisis; Should government intervene?

Chief Executive, The, June, 2008 by Richard A. Epstein

Is it bailout time? One of the hardest choices is to decide when, if ever, to intervene in private markets. The fast-moving deterioration of credit markets has made that decision more critical than ever, both for high government officials and for CEOs.

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The recent decision of the Federal Reserve Bank to broker the deal between Bear Stearns and J.P. Morgan was done over one frantic March weekend, and many observers, including myself, reluctantly concluded that this deal made sense for two reasons. First, the failure of any great commercial bank could start a cascade that might well bring down other banks that were counter-parties to Bear Stearns on a plethora of intricate short-term financial transactions. Second, ironically, the existing shareholders of Bear Stearns were left reeling because the original $2 per share price (even quadrupled) wiped out huge portions of their ample stakes in what had once been a financial juggernaut. The stabilization of financial markets may--the jury is still out-have been worth the $30 billion that the Fed has put on the line.

Democratic presidential nominees Hillary Clinton and Barack Obama have insisted that it is rank favoritism for the government to bail out the banks but do nothing to help the thousands of homeowners facing looming foreclosure. In their view, what's a good response for one crisis is good for another. And judging from the daily proposals to relieve the pain, both candidates (and a more reluctant John McCain) have a lot of company in both parties.

Unfortunately, the conventional wisdom is wrong. The dislocations in slow-moving individual mortgage transactions are a different kettle of fish from the high-turnover Bear Stearns deals. In the home loan market, the best thing is for governments to do nothing out of the ordinary. The usual protections against abusive loans now in place should of course be enforced. But added measures will only add fuel to the proverbial fire. Make it clear that no life buoy is forthcoming, and private firms, led by their CEOs, should be given every incentive to sort out the messes they find themselves in. They should unwind past unwise transactions, avoid the future repetition of past mistakes, or both. Here's why.

Harsh Realities

The origin of the subprime mess lies in the regrettable if indefatigable optimism of too many lenders and borrowers alike that the good times would continue to roll. There are no heroes in this tale of woe. Aggressive lenders required little or no collateral from eager borrowers who sought to live beyond their means. In many instances borrowers accepted low "teaser" rates, confident that they could refinance their loans or sell the property before any rate hike kicked in. But like all bubbles, this one burst, leaving in its wake a large inventory of "underwater" properties worth less than the mortgages draped over them. The ensuing spate of foreclosures has placed a lot of pressure on both the courts and the credit system.

To politicians of all persuasions, any economic dislocation counts as an open invitation for further government meddling. Hillary Clinton's program, unveiled this past March, represents the most aggressive--and unwise-response to the lending meltdown. The recent bipartisan Congressional stimulus package represents an ambitious, if futile, effort to deal with the larger macroeconomic implications of the crisis. Neither can do any good.

Start with some simple fundamentals. Suppose the government holds tight and does nothing. Clearly hundreds of thousands of homeowners will be subject to foreclosure. Not a good thing in itself, but better than the alternatives. On the borrower side, many of these individuals have made either a small or no down payment in their house. Typically, their default comes relatively early in the loan cycle so that they have done little to pay down the loan. Often they are able to live, as it were, rent-free until their eviction, several months down the road. At this point, their credit is probably not sufficient to pay any deficiency judgment. With tighter credit restrictions in place, they will be forced to rent, and perhaps move down a step. But they will be free and clear of all liabilities, able to participate in the market, without living beyond their means. Some hardship, to be sure, but right now there are private parties advertising do-it-yourself kits that allow hard-pressed homeowners to convey a deed in lieu of foreclosure that speeds up their extrication from a most unhappy situation.

The banks for their part are likely to lose more than the defaulting homeowners at the end of the day. Tough. They may be forced to unload the foreclosed properties for less than the unpaid loans. But once sold, the new buyers are likely to prove more stable than those they replaced. The past losses will be fully recognized on the books, thereby closing the gap between the accounting entries and the economic realities. Once sold off, they can raise new sources of capital without having their equity contributors guess at the amount of their unliquidated liabilities. Properties now make it back into the market, without inherited liabilities.