The Bush Administration and the Federal Reserve appear to be on the verge of offering a bailout package to the mortgage lenders and homeowners who are the primary actors in the current housing market slump.
This is sobering news, for government action of this kind would almost certainly prolong the current housing market crisis, in addition to weakening the long-term health and prospects of the market.
The housing market hit a slump in late 2007, when over 100 lending companies filed for bankruptcy, as a result of borrowers defaulting on mortgages. These borrowers had taken on adjustable rate mortgages at a time when the housing market was doing well; the borrowers signed for the ARMs with the intention of refinancing later at rates more advantageous to them.
These "subprime" mortgages, so named because of the higher risk involved on the side of the lender, have interest rates which start out low but quickly increase as a way to compensate the lenders for the increased risk. As it turns out, many of the borrowers were unable to make their payments when the interest rates went up; they defaulted, and the lenders were forced to declare bankruptcy.
How did this happen? A variety of factors were at play in the bursting of the housing bubble, but it appears that two key variables were dishonest borrowers, and overeager lenders. BasePoint Analytics, a firm which tracks and studies fraud, determined that many people who applied for subprime mortgages and later defaulted simply lied about their income. This deception went undiscovered because the lenders did not vet the applicants thoroughly enough before approving the mortgages.[i]
The economic repercussions of the housing slump are serious enough that President Bush and the chairman of the Fed are both considering some kind of bailout in an attempt to alleviate both consumers and investors; however, that would be a serious mistake.
Our economy runs largely off of trust that we extend towards millions, even billions of strangers--people we have not met and probably never will. When a consumer orders a book off Amazon.com with his or her credit card, there is no face-to-face meeting with the book manufacturers, the shipping service, the webmaster who maintains Amazon's online portal, or the bankers who manage the electronic transfer of money. Yet, the consumer is confident that his or her book will arrive in the mail, and the bank account in question will be debited for the proper amount.
This kind of automatic trust is what sustains our economy and allows it to grow; it cannot exist in an environment where actions do not have consequences, where rules do not matter. The iron law of economic trust is cause and effect; this means that irresponsible behavior by consumers and investors alike must carry a penalty. This acts as a negative incentive for irresponsibility and reinforces smart lending and borrowing.
A government bailout not only overturns the balance of cause and effect, also encourages lenders and borrowers to act in the knowledge that the government is waiting to step in and fix their mistakes once the pain threshold is high enough.
The housing market will undergo a period of short-term pain, but that is better than a loss of long-term viability. If the Fed is thinking of pumping Reserve dollars into the ailing housing market, they might do well to heed the words of Jesus in the parable of the talents. A master entrusted three of his servants with varying amounts of money to invest.
Upon returning, he found that two had chosen wisely and turned a profit; the third had chosen foolishly and put his money in a hole in the ground, wasting any opportunity for investment. The master had these words for the faithful: "'Well done, good and faithful servant! You have been faithful with a few things; I will put you in charge of many things. Come and share your master's happiness!'"
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To the servant who had acted foolishly, the master replied, "you should have put my money on deposit with the bankers, so that when I returned I would have received it back with interest. Take the talent from him and give it to the one who has the ten talents. For everyone who has will be given more, and he will have an abundance. Whoever does not have, even what he has will be taken from him.'"[ii]
