Moral Hazard, the Housing Market and Globalization
Roger@MyHomeLender.com
During 2001 and leading up to the revelations of Enron's financial mismanagement we regularly discussed the concept of moral hazard.
Moral hazard occurs when there is a failure to abide by the social contract binding both parties to a transaction; i.e. someone lied. This lie distorts the risk versus reward relationship of the transaction and results in one party incurring a greater risk than they should.
This term is usually used to describe the moral hazard associated with people lying to their insurance companies about auto accidents or health issues, etc.
In the capital markets moral hazard is incurred when loans are made by money centers to large companies with expectations that if the loan goes bad the tax payer will fund the loss.
The increased costs caused by moral hazard are then born by all of society through higher insurance premiums and costs of capital and ultimately tax payer funded bail outs in the most catastrophic events.
Economic slow downs always cause moral hazard to become evident.
Yesterday I was on the air in Portland, Oregon with Chad Burton discussing the issue of housing. A local Economist had been on his show before me discussing the positive aspects of increased home "ownership" in the US and the resulting perceived positive indicator this portends for future economic activity in the US.
There is an old saying in economics: As goes housing, so goes the economy.
Typically an increase in the number of home buyers is an indication of growing incomes and increased savings along with a net increase in financial and social responsibility on the part of home buyers.
In that vein the current all time record number of home "owners" in the US at 67% of the "adult" population, would seem to be indicative of increasing prospects for economic activity.
But before drawing this conclusion we must first ask why has home ownership increased to record highs over the past couple of years and what is a home owner.
Home ownership has increased principally because of manipulation of loan qualification guidelines by the Government Sponsored Enterprises, Fannie Mae and Freddie Mac, which account for about 65% of all mortgage lending in the US.
A home "owner" is a term used to describe a mortgage borrower, someone beholden to the bankers.
The manipulation of qualifying guidelines has resulted in more home "owners".
This has been achieved by reducing the qualification limits so that mortgage borrowers can access money for home purchases with little to no money down today. Just a few years ago borrowers need to provide a 5% down payment minimum and this money had to come from their savings, not from a gift offered by a parent or some other source.
Additionally the credit worthiness of the borrowers has been significantly lowered to allow borrowers with current credit issues access to mortgage money.
In other words, the housing market has not been performing well because of strong fundamental economic activity resulting from responsibility on the part of society and causing incomes to rise allowing more borrowers to meet qualification guidelines.
The bar has been lowered and lowered quickly by the GSE's
This has resulted in a parabolic increase in the number of potential home buyers because of eased access to mortgage money. This has also caused a supply, demand mismatch of available housing versus the number of new buyers at a rate the housing market has been racing to adjust to. This has been the primary driving factor in housing price appreciation over the past 3 years.
But, why have the GSE's lowered the qualification guidelines? Is there any PRUDENT economic reason to believe that lowering qualification guidelines will reduce the lenders risk, increase returns, stimulate the economy and allow for the next "new" economic paradigm; wherein everyone is a home "owner"?
Of course not.
Even as home "ownership" has increased to all time records, the average equity position in our homes has dropped to post WW2 lows and foreclosures are now at post WW2 highs.
So, why then have the GSE's lowered their qualifications?
The answer is simple and complex. These organizations are not charities and should not be used for social engineering purposes but that is clearly the vein in which they are now operating, partly.
Just as the FED has lowered interest rates 12 times and printed federal reserve notes; i.e. dollars, in an attempt to keep money flowing through the economy the GSE's have done the same by lowering qualification guidelines.
Monetary stimulus has thus far failed to cause an increase in capital borrowing, spending and investing on the part of companies.
Monetary stimulus along with mortgage stimulus however have worked wonders in the housing market over the past couple of years and caused the housing boom we are currently experiencing.
The result has been that the US consumer rather than the investor is carrying the US economy. This is resulting in a transfer of risk from the money centers and companies to the consumer in the US.
As mortgage qualifications decrease the risks of foreclosures increase. The GSE's apparent willingness to absorb this risk is irrational and indicative of moral hazard. As there is no economic logic to lowering qualifications guidelines into a slowing economy and that all economic logic warrants an increase in qualifications guidelines the most probable rational for doing so is that the GSE's have adopted a too big to be allowed to fail attitude.
In other words, if the economic slow down continues and foreclosures increase beyond the point of the GSE's ability to absorb them that the US Federal Government will be forced into funding the losses with tax payer dollars.
Becoming a home owner does not make a person financially and socially responsible. Becoming a home owner is the reward for having already been responsible.
This is a part of the social contract between lenders and borrowers. Lenders agree to prudently make funds available and borrowers agree to repay these loans as best they can. This social contract, trust, is the backbone of our capitalist economic system.
Providing mortgage money to borrowers whom have either not shown an ability to act responsibly or worse have already proven that they have not acted responsibly is not prudent. Making loans to them will not make them socially responsible. That is putting the cart before the horse and increasing lending risk imprudently.
The GSE's must be aware of this and yet they have attempted to do just that. Further, the Fed, Treasury and regulatory officials must be aware of this but have said nothing about it. This is indicative of a moral hazard being incurred by our society at these levels. Near term housing strength helps keep the economy going and thus warrants the transfer risk to these new borrowers as a result seems to be the logic or more appropriately excuse for allowing this to occur. Mortgages are being used as social engineering tools now in an attempt to increase economic activity.
But what about the borrowers? Would you give your 16 year old daughter a Ferrari on the day she got her drivers license? Of course not, she hasn't proven herself capable of handling it. And if you did so, what would your neighbors say? Who would the courts hold responsible in the event she had an accident?
The social contract has been violated. The GSE's are allowing young adults to put themselves into financial situations they have not proven themselves capable of handling and causing them to incur risk they clearly do not understand. This risk is the lenders risk being transferred to these kids by the lenders in an attempt to keep cash flow and revenues up at all costs. This is being done while authorities that know better are turning a blind eye because it fits within their immediate needs as well.
We are asking these kids to shoulder the brunt of the economic downturn in the same way we ask them to go to war. The difference is that we have become their enemies; not some foreign threat to our life, liberty or property.
Even as some are championing the increase in home "ownership", foreclosures are already at record levels and continuing to rise. These young adults are entering society with decimated financial records that will reek havoc on the rest of their lives. Defaulting on a mortgage is not like defaulting on a car loan, credit card or student loan. Defaulting on a mortgage will have serious long term ramifications for these young adults. It will keep them from getting new credit, another mortgage and worse will decrease their chances of becoming gainfully employed as more and more employers are using credit histories when considering applicants for employment. The risk we are transferring to them is the result of imprudent financial decisions on the part of we adults over the past several years. What is an acceptable level of loss? How many of these kids have to have their lives destroyed before we start accepting the responsibility for our excesses, stop transferring it to them and mandate that our political and business leaders stop.
What we are doing is immoral and unethical and will most probably cause very bad results for society.
This is exactly what some of the sub-prime credit card companies have been doing by offering credit cards to college students whom don't even have jobs. These companies have trapped themselves in a cycle once they started this. As loan default rates increased they had to lower qualifications even further to allow for near term cash flow in an attempt to offset current losses. This is the equivalent of the gambler that is losing putting more and more money at risk in an attempt to regain losses. At some point the money runs out.
This is also why globalization, which is the export of US social, economic and political philosophies, is not being greeted with open arms by many around the world.
The US has been able to become the worlds greatest ever shining light for political and economic discourse because of our strong social system.
We are now exporting our economic and political philosophies with the promise to the world that if they adopt them they will create a stronger society; a copy of our society. We are using our systems as social engineering experiments around the world and putting the cart before the horse. The strength of our system is because of our social system not the other way around.
Our social contract is based on honesty, ethics, and respect for personal freedoms. Ironically however, we violate our own code in an apparent end justifies the means way doing things when we force others to adopt our systems.
This is worse than a do as I say not as I do philosophy. We are asking countries to adopt our systems because it fits the goals of our corporate state not because it is good for them. We are asking our young adults to carry the burden of our recent past financial abuses not because it is good for them but because it fits our near term needs.
I don't like where we are heading in this country and we each as individuals better stand up and take a look in the mirror.
Finally, I do not expect my commentary to be the cause of a groundswell of public responsibility. This is merely offered to give you some frame of reference as to what is actually occurring in the economy today.
This situation is long past the corrective phase wherein the GSE's can reverse course and readopt more stringent underwriting guidelines.
On the contrary the only plausible political course form here will be to increase the manipulation of housing primarily through the manipulation of long term treasury yields.
The FED along with international investors will drive the 10 year treasury yield down to 3% in an attempt to protect their own assets. As a result and coincidentally the 30 year fixed rate mortgage rate will fall to 5% at PAR and result in the last hoorah for home buyers and refinancers.
Roger Arnold
Roger@MyHomeLender.com |
