Chuck Ponzi March 28th, 2007

With recent talk from Senator Dodd about a bailout for the “little man”,  we’re left to ponder who a bailout would really help or hurt, who pays, and who benefits from it.

Luckily, the guys over at Wharton (which, surprisingly have more credibility than some anonymous guy with a blog) have given the media world some soundbites to play over and over again.

We began speaking of Moral Hazard once the downturn started.  When you fix someone else’s problem, you create an incentive for that person to do the thing that caused the problem… they’ll just get bailed out again.

From Wharton’s school of Business:

“I think that for the moment, they should probably leave it alone,” says Joseph Gyourko, professor of real estate and finance at Wharton, warning that bailouts can make people more reckless in the future. “We don’t want to introduce moral hazard …. We don’t understand this very well right now, so any regulation is probably going to be wrong or imprecise.”

In fact, he says, the market is already correcting the problem. Lenders have dramatically cut their offerings of the most hazardous products –such as loans that require no down payment or proof of the borrower’s income, or those which allow borrowers to decide for themselves how much to pay each month.

Ken Thomas, a lecturer on finance at Wharton, argues that people and institutions that make risky choices are usually best left to suffer the consequences. “When we had the last big financial meltdown with stocks in 2001, did we consider bailing out those who lost money in the dot-com crash?” he asks. “We try to have markets regulate, not the government. Markets do a much better job.”

What we are seeing right now is that the markets are reacting to better information than they previously had.  Like Newton’s 3rd law of motion:  For every action there is an equal and opposite reaction.  In Economics, we say “There’s No Such Thing As A Free Lunch”

Besides, who would a bailout help?  Certainly not homeowners.  How could you weed out who where truly in trouble, and who were opportunists?  Wouldn’t that saving create a need that you would later need to feed?  What about my free lunch too?  Would I (as a taxpayer) need to pay for someone else’s indiscretion?  What about the money I lost in the stock market in 2001, can I get a refund there too?   For those subprime homeowners… many of them came to the table with bad credit and no cash.  So, they’re leaving with bad credit and no cash, is their life that much worse off, and is that our collective problem that they cannot manage money?

On the other hand, lenders wouldn’t lose a penny.  They were the ones who recklessly took risks and offered the loans to the higher credit risk for a higher return.  A bailout would only serve to line their pockets for taking outsized risks.  There’s a reason that it’s called risk in the first place.

Dodd, chairman of the Senate Banking Committee, plans to introduce legislation to protect homeowners from foreclosure and to crack down on predatory lenders who pushed high-risk loans on unsuspecting borrowers. Clinton is pushing for a federally mandated “foreclosure timeout” that would give homeowners more time to catch up on their payments, and she wants to curtail the prepayment penalties that make it hard for troubled borrowers to refinance. The National Community Reinvestment Coalition wants the Federal Housing Administration to be given new power to refinance subprime borrowers’ loans, and it wants the federal government to set up a fund for rescuing low-income homeowners.

Senator Dodd, you are treading on thin ice.  Be careful where you step.  The next one could be the wrong one.  Nothing like a good scandal to end one’s political career.  We all know you’re in bed with the financing organizations… all it takes is one false step.

• Credit Bubble , Debt , Lending Standards , Mean Reversion