Moral Hazard

Another day, and the stock market is in in the tank. The Federal Reserve's efforts to stave off the recession are futile. We can only hope their tinkering will not fuel inflation into an economic firestorm like we have never before seen.

There are a lot of reasons for this, but the impetus is the mortgage crisis. Back just before the turn of the century, it finally dawned on folks that the dot com New Economy business model was an emperor with no clothes. No matter how gee whiz your technology is, it is simply not possible to make money by giving stuff away for free.

The Wall Street whizzes were able to soften the dot com collapse by coming up with more and more sophisticated ways to wrap mortgages together and make them into secured instruments, which became a hot item of trade. It was largely this gimmick which funded the economic expansion of the last seven years. And it was all encouraged by Alan Greenspan and the Fed.

But it was the securitization of mortgages which has made it impossible for the owners of mortgages to deal with the current situation.

In the last few years lenders were willing to give anyone who could breathe a mortgage. They did this because there was a huge and never ending appetite for more securitized mortgage instruments on Wall Street.

A lot of these mortgages had terms that would make a Mafia loan shark blush. It was the now familiar gimmick of a a one percent rate, that would, in a couple years, change into a usurious twenty-three percent.

When folks couldn't pay these obscene mortgage rates, at first there was minor irritation at the lowlifes for not reading the fine print, and living beyond their means, which meant the brokers might actually have to sell their summer house in the Hamptons.

As the crisis deepened there is just panic, and it has infected the world economy. But we still blame the greedy unsophisticated home buyers who got in over their head.

But the financial markets are unwilling to do anything to help, because of something called moral hazard.

Capitalism has nothing to do with morality. It is about greed. People take risks because they want to make money.

The current problem is the banks are not able, or are unwilling, to act in a way that is in their best interest. A lot of this is due to the securitization of mortgages. And the rest is due to the uncapitalistic idea of moral hazard, which Ben Bernake was blathering about on Capital Hill last week.

Banks do not like foreclosures. They loose the principle on the loan they made, all the interest, pay hyped up attorneys fees, and end up selling the property at a huge loss.

So it is in their interest to do anything they can to forestall a foreclosure—or at least is should be, if they were acting on purely capitalistic principles. The bank should be eager to negotiate if it is a situation where the mortgage can be saved. It is better to taken a decreased interest rate, or renegotiate the loan, than to take a total dive with a foreclosure.

In the past this has been the case. But nowadays a lot of these high and mighty people are piously saying they do not want to try to work these loans out because it will encourage home buyers to act irresponsibly in the future. They will enter into transactions they can not afford, knowing that eventually they will get bailed out.

However, if we must talk about morality here, lets not leave the lenders out.

Homeowners knew that the mortgages they were entering into would be unaffordable once the high interest period kicked in. But when they asked the mortgage broker, who until three months ago had been a long haul truck driver, he would tell them don't worry—we will just refinance before then. Everyone now blames the the stupid borrowers, but it is the financial wizards who really should take a hit. In all rising economic markets no one has any historical perspective. These hot markets always eventually collapse.

But now that the chickens are coming home to roost the banks should be scrambling to salvage their investments, not giving priggish admonishments about teaching these homeowners a lesson. That is not capitalistic. Although it should not be necessary to force the lenders to act in their best interest, this is a place where government intervention is necessary. The bankruptcy courts should be permitted to rewrite these loans—it is in the best interest of each side—and the economy.

However the other problem is that mortgages are now security instruments. A lot of homeowners in distress do not even know who to deal with to renegotiate the terms of the loan. The mortgage has been sliced, diced and spread into several pieces of papers, with multiple owners.

The owners of these securities do not want to adjust the rates on any of the mortgages they own pieces of, even if they could sort it out, because this will decrease the face value of the security instrument, never mind that the actual value is not much better than zilch. As this begins to dawn on traders, the market moves the trading value of these securities toward their real value—the big goose egg.

The securitizaton of mortgages has essentially made it impossible for anyone to act in their own selfish best interest. And even when they can, they are reluctant, because of their preachy morality.

The current economic crisis is not a failure of capitalism, it is largely the result of getting too economically cute, and eliminating the free market forces that would correct the situation.

And then the whole thing is exacerbated with a hypocritical overlay of morality.