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Banks Should Forget the Moral Hazard for Now

Some 75% of the ARM-type mortgages used LIBOR as their base, adding a fixed premium to set the total interest rate. The concept was that the base rate would reflect inflation, protecting the lender against any increase in inflation, but simultaneously providing a small decrease in the overall rate for borrowers as the lender no longer had to factor future inflation into his consideration.

But today we find that the LIBOR is no longer a proxy for inflation; rather it is a proxy for fear -- fear that the principal itself is at risk. As a result there are millions of otherwise well-performing loans now put at risk as the underlying loan rate jumps some 3 percentage points above inflation, unfairly costing such borrowers additional hundreds to thousands of dollars per month.

With all the talk about the home prices in decline, and what to do for the relatively small number of borrowers who bought at a peak, we need to keep in mind the millions of additional homeowners who are seeing their loan payments skyrocket by being tied to a malperforming metric.