Subprime Mess: No One's Fault But Our Own

by: Vitaliy Katsenelson, CFA

The housing bubble that was fueled by multidecade low interest rates priced many people out of their dream homes. But instead of settling for less or renting, people went after their American dream with a vengeance - taking out adjustable-rate, interest-only or, even worse, negative-amortization loans.

Good things end, and great things end with a big bang; the burst of the nationwide housing bubble has left many with shattered homeownership dreams and financial despair.

And now the blame game starts. It must be the builder who charged too much for the house, or the “blood-sucking” mortgage broker who facilitated a loan, or the bank for extending credit we should never have had. Now, there’s a new extreme - the investors who purchased our mortgage with thousands of others from financial institutions.

The blame falls on us and none of the above. Though we want to blame the financial institutions for coming up with these products, as long as loan terms were fully disclosed, it is our responsibility to make the right financial decisions, not theirs. Any product can be dangerous if not used responsibly. Even a hair dryer, if used while taking a shower, could lead to untimely death. The financial products (i.e. mortgages, home-equity loans, credit cards) are electrified by compounding, and if not used appropriately, could lead to financial distress.

Pleading ignorance is disingenuous. With the exception of outright fraud, buyers knew they were biting off more than they could chew. They knew interest rates would reset and mortgage payments could increase, or at least it was their job to find out before they committed to the biggest purchase of their life. But that was in the future, and they lived in the now. The future is today, and there is a price to pay. We need to stop blaming everybody but ourselves and own up to our mistakes.

We hear sad, heartbreaking stories of eviction, broken families and pecuniary anguish resulting from people losing their homes all over the country. Of course, we want to help these folks in trouble. Our first instinct is to look at our almighty government for help. Though government sounds like an ambiguous third party, it is not - it is you and me. Should you and I carry the burden of those who made irresponsible or simply bad decisions? Money is a finite commodity, thus for the government to bail out the victims of this housing debacle, it either will have to raise taxes, cut spending or both. Yes, you and I will be paying higher taxes and/or money will be diverted from cancer research or other social programs because your neighbor elected to live in a larger house, better neighborhood or to have a greener lawn.

But that is just the beginning. The largest cost of a government bailout is the one that is not apparent at first - the moral hazard. In a free economy, incentives are set up in a way so that decisions made in our best interest also benefit society,or the system as a whole. Introduce moral hazard into the equation and individual decisions can benefit participants but hurt the system. The unintended consequence of a government bailout could be catastrophic.

The politician will tell you that only victims will be assisted. They’ll make sure not to call it a bailout. It is close to impossible to identify who the true victims are. Were they the ones with bad credit who took out subprime or Alt-A loans? Or the ones who are facing ARM resets? Maybe the ones whose house value declined because their neighbor foreclosed on his?

Politicians will come up with creative definitions of victim, but the result will be the same - the number of people who fall under the victim umbrella will mushroom exponentially, far exceeding original expectations - the unintended consequences. Homeowners who had all intentions of paying on their mortgages will ask for the government’s (now available) assistance. The ones who could not afford their house in the first place will get a couple years of free rent out of the system, ultimately defaulting on their mortgage a couple of years down the road.

In addition, the bailout will introduce an asymmetric payoff for current and future homeowners: Owning a house will become a risk-free endeavor. If your house price goes up, great. If it goes down, you claim to be a victim and society compensates you for the risk you’ve taken. A risk-free, utopian paradise, isn’t it? This will set the stage for an even greater next housing crisis.

The next couple of years will uncover more fraud committed by some unscrupulous mortgage brokers and banks. Some small elements of fraud are uncovered at the end of each boom: the junk bond boom of the late 1980s, S&L crisis of the early 1990s, the Internet bubble of the late ’90s, and it will happen again. Our economic and legal systems are equipped to deal with these people - they’ll go to prison. And politicians, like vultures, will feed on our misplaced anger. Like superheroes, they stand up to protect the little people (us) against the evil empire by creating “housing reforms.” But you cannot legislate common sense. With freedom comes responsibility. Do we really want to give up freedom and have government bureaucrats decide who should or should not get a loan? Instead, lawmakers should focus on making the lending process simpler and more transparent, where the terms of the loan are clearly spelled out on one page.

Doing nothing is the hardest thing to do when you see people in distress. We are a compassionate people, and we want to help. But there are times when we have to restrain ourselves and do as little as possible because by helping some you’ll hurt many others. This is one of those times. The current crisis will pass, as have many before. Let’s not escalate the magnitude of the next one by irresponsible actions.

This article originally was published in the Rocky Mountain News