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Moral Hazard of Financial Reform

At 5:39am this morning, conferees between the US House and Senate agreed to a compromise to the sweeping Financial Reform bill that will make the largest changes to the US banking system since the Great Depression.  It still needs to pass both the House and Senate and then be sent to President Obama for his signature, all which are expected to happen before July 4th.

The legislation is intended to address many problems and issues.  One of the primary purposes of the bill was to eliminate the “moral hazard” of the “too big to fail” justification for the unprecedented government intervention in the financial markets in the fall of 2008. 

Part of the impetus for the creation of the $700 billion TARP  was to prevent certain financial institutions from failing.  Government and industry leaders were concerned that the US financial system (and potentially the global system) would collapse if these large institutions went under.  Their influence had grown so large that they were too big to fail.

Democrats, Republicans, Independents, liberals and conservatives all had concerns with a perceived bailout of Wall Street bankers.  Liberals were reluctant to use taxpayer dollars to save billion-dollar firms with a reputation for paying out multi-million dollar bonuses to employees.  Conservatives were opposed to government intrusion into the free market system.  

Most people were concerned with the “moral hazards” of the bailout.  Rescuing the firms was viewed as rewarding bad behavior by shielding the companies from the consequences of their poor business decisions.  Furthermore, once you are protected from the results of risky or bad choices, what’s to stop you from engaging in similar behavior down the road?

There were multiple players and many factors that contributed to the financial meltdown in 2008.  Two of those players were Fannie Mae and Freddie Mac (Fannie and Freddie).  They may not be primarily at fault, but they share in the culpability.  These institutions effectively allowed banks and mortgage companies to issue subprime and other high-risk mortgages.

You can blame traders and investment bankers for gambling with things such as credit default swaps.   However you must also look to the underlying assets they were betting on… home mortgages packaged into mortgage backed securities guaranteed by Fannie and Freddie.  The rise in mortgage defaults caused the mortgage backed securities to implode in value, which resulted in the banks coughing up billions of dollars to cover their losses from derivatives trading. Are Fannie and Freddie solely at fault?  Absolutely not.  However, they did have a role, yet they are noticeably absent from the Financial Reform legislation.

The legislation is supposed to kill the notion that any institution is too big to fail and address the moral hazard issue.  Time will tell if it’s successful.  However, there is one moral hazard from this crisis that has yet to be addressed – Fannie Mae and Freddie Mac.

I believe that Fannie and Freddie also possess a moral hazard.  It’s doubtful that banks would have written many subprime loans if they had to hold those loans on their books.  It would have been too risky.  Fannie and Freddie’s willingness to buy these loans and guarantee payment gave the mortgage originators an incentive to write more of the loans.

In September 2008, the US Government put Fannie and Freddie under conservatorship.  Although still a publicly held company, the US taxpayers own 80% of each enterprise.  To date, we’ve put over $140 billion into them to keep them afloat.  Earlier this year, President Obama lifted the $400 billion cap to the government guarantee, which basically ensures that any security backed by Fannie and Freddie will be fully paid by the US government.  Therein lies the same moral hazard as with the Wall Street banks.  If the government  the losses at Fannie and Freddie, what’s to stop them from taking on the next wave of high-risk mortgages, with the intent of increasing home ownership or stimulating the residential real estate sector?

Congressional leaders have said they will address Fannie and Freddie at a later date.  Excuse my skepticism, but I don’t see it happening any time soon.  It took over a year to get this legislation passed.  I doubt that Congress wants to immediately jump back in the fray on this issue, plus they have many other priorities and issues to contend with, including an election in four months.

With all the publicity of TARP and Wall Street bailouts, Fannie and Freddie may be the granddaddy of all bailouts.  The government has already pumped $140 billion into these companies, and there doesn’t appear to be an end in sight.  These companies have loaned or guaranteed about half of the $12 trillion in US mortgages.  With an estimate of 15-20% of all homes in the US currently worth less than their mortgage and a steadily climbing foreclosure rate, it’s scary to think of how big this could get.  There was probably a reason that President Obama lifted the $400 billion cap.

A lot of this may seem political and irrelevant to you, but remember that’s your tax dollars at stake.  I also think the moral hazard principle applies to Wall Street bankers, government entities and individuals.  If you don’t have to pay the price for your actions, what’s to keep you from making stupid mistakes or engaging in risky behavior?  Positive encouragement can be a great incentive to changing behavior, but the pain of failure can be the greatest incentive to change.

This applies to all areas of life, including finances.  Unless you have someone funding your lifestyle, you may not have a moral hazard with your own money.  You are not too big to fail and will pay the price of any poor decisions you make.  However, the principle of the “moral hazard” applies anytime you make a financial decision without regard to the consequences because someone else is picking up the tab.  You may not be paying, but in the end, it will cost someone.

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Lending Lesson Not Yet Learned

On June 14, 2010, the Wall Street Journal printed an op-ed piece about the politicizing of the Federal Reserve System, which has functioned for 97 years with minimal political meddling.  There are provisions in both the House and Senate Financial Services Reform bills which have the potential to introduce a lot of politics into the U.S. monetary policy.

One thing mentioned in the article is the creation of a high-ranking position at each of the 12 regional federal banks.  This Presidential appointment would be responsible to “ensure equal employment opportunity and the racial, ethnic and gender diversity” and “increase the participation of minority-owned and women-owned businesses in the programs and contracts.”  Seems rather benign until you consider the backdrop of the mortgage meltdown over the past couple of years.

One of the factors that contributed to the present financial crisis and economic recession was issuing home mortgages to people who had a dubious ability to repay.  The Federal government’s goal for more than 20 years of increasing home ownership resulted in a gradual change of lending standards (e.g., subprime loans, 100% financing and option ARM’s). 

Twenty years ago virtually every banker would have considered it insane to lend on any of these terms, yet they did.  Why? Because they were able to off-load these loans to Fannie Mae, Freddie Mac and other investors.  The government was willing to back the loans because it furthered their goal of increased home ownership.

Like a pendulum, the lending standards over the past two years have swung dramatically in the other direction.  Clients who purchased or refinanced their home have experienced difficulty getting approved, even though they had a securities portfolio multiples times the value of the loan they were seeking.  In less than 12 months lenders went from giving loans to people who couldn’t repay to virtually refusing loans to those who don’t need to borrow.

A loan is different from a gift… the money is supposed to be repaid.   If you have ever lent money to someone, even $5, you know the greatest risk is that you won’t get repaid. Common sense would dictate that a borrower’s ability to repay is the most important criteria when making a loan. 

In Martin Luther King Jr.’s famous I Have a Dream speech, he said he dreamed that “my four little children will one day live in a nation where they will not be judged by the color of their skin, but by the content of their character.” I’m sure that banking practices were not on his mind the day he delivered his speech, but the principle applies. No one should be denied a loan based upon their race or gender, but you also should not get a loan, or preferential terms because of it either. The concern with these political appointees is that they will exert pressure on the banks to lend based upon gender or race, rather than strictly on the merits of the loan. 

There are many lessons to be learned from the financial crisis of 2008.  One of those lessons is to deny loans to people who can’t reasonably repay, even if it’s for a good cause.  Politicians should not pressure banks to lend to people who can’t repay.  If they do, it’s a lending lesson they have not yet learned.