When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 3of3)

In the first two parts of this series I discussed two of the leading programs currently being considered to solve the home mortgage crisis in America. In this final installment I would like to address a widely ignored issue, the moral hazard these policies create by providing publicly funded safety nets for risky practices. I do not contest that something needs to be done to protect our financial institutions, however I do believe it should be considering when deciding which is the best rescue policy.


Circling back to a discussion I started in “Truly understanding the credit crisis, and why this isn’t really all Alan Greenspans’s fault” I think it is important to examine the risk structure these policies are creating. The lending side of this crisis was fueled by an incentive structure that put risk onto public entities while the benefits were held by private banks. Both proposals presented in this series make this incentive structure worse by moving more risk from banks to the Government, thereby creating a moral hazard which encourages risky behavior. Given the situation we are in we may be left with choosing the better of two evils for the sake of saving our country’s financial market, but it is worth an exercise to examine both proposals through this lens.

A loan guarantee is a strong moral hazard for both the lender and the borrower. In this case the borrower is rewarded by receiving a government backing for real estate they cannot (and never could) really afford and the lender receives an unwarranted guarantee for lending to risky borrowers. It is easy to see the moral hazard here. If the bank is able to lend to risky borrowers in good times, and then receive government backing for these loans in bad, what becomes of the risk adverse incentive to have strict underwriting requirements? I also outlined in my first installment of this series how this program creates an extra reward for banks if they foreclose, possibly creating more of an incentive to foreclose. This program creates a win win deal for banks (win if they continue poor underwriting practices, and win if their bets go wrong and have to foreclose) who made poor decisions. The guarantee program has not included any discussion about adding cost to banks or troubled home owners to make the government option a last resort, and a guarantee inherently does not have the flexibility to punish lenders for making the risky loan in the first place. Of all options this one seems to have the worst long term consequences.[1]

A program similar to the HOLC also has some moral hazard issues, but can be designed to “punish” borrowers, and to some extend lenders, for their risks. As I noted in part 2 extending the term of mortgages are a key part of this policy. As such borrowers will need to maintain their entire debt service. A borrower will not be rewarded for taking the risk of an unsustainable home purchase price. If I were designing this policy I would also recommend adding some additional costs onto the troubled buyer. These costs should be high enough to prevent performing mortgage holders from abandoning their private loan because the government program is more favorable. These costs can best be added through deed restrictions, which could prevent a homeowner from selling their property for a certain time period. It is similar to the way New York City (and possibly other cities) prevent recipients of below market housing to profit by quickly flipping their property. The policy will keep troubled borrowers in their homes, punish them for risky decisions, and make the government program a last resort instead of a first. For banks the story is not as easy. A cost can be added by purchasing the mortgage at "bargain prices" essentially paying some discount from the principle+amortized value of the loan. This will further help the government to reissue the loan at a lower interest rate. But this punishment should not be so great that the bank is better off foreclosing. It will have to be a delicate balancing act but at least the flexibility exists.

Hopefully Alan Greenspan was right when he last spoke to Congress saying this is a “once in a century event.” If true, the Government will not be constantly needed to keep our financial markets healthy. It is difficult to think of a perfect policy where a Moral Hazard could be completely avoided, after the $700 Billion bailout bill was past the damage was already done. We can however try to prevent the next crisis. Any government bail out program must come with some innovative, yet flexible, new regulation. I think the bulk of this new regulation will be left to our next President (the Republican's do not want to touch that) so I wait with baited breath to see what President Obama will be coming up with.

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[1] With all discussion about how bad government guarantees are, I thought it appropriate to describe a situation where it works. The government can solve a market failure with a guarantee. Micro loans (average of $10,000) are a great example. These loans are too costly to issue for banks because they are risky and provide low return, but are vital for micro-business (1-15 employees). A guarantee on these loans make them more cost efficient because they lower the risk, giving micro-business access to much needed credit and banks a cost savings inducing them to lend. Note these are always for new loans and do not address businesses that are over leveraged.

Nice To Know Henry Paulson Agrees a Loan Guarantee Will Not Work

Today’s Wall Street Journal shed some new light on the Government’s plan to create a loan guarantee program. The article indicates that Henry Paulson seems to agree with my analysis that a programs only targeting interest rates will not solve the fundamentals of the mortgage crisis, namely that the average troubled borrower is overleveraged. The October 30th New York Times article was a bit vague on detail for the loan guarantee and led me to believe this was a program being pushed by the Treasury. Today’s WSJ (sorry the website link above is subscription only, it appears p. A2 in the paper) describes the plan as one of several plans the White House is considering, and is being formulated and pushed by the FDIC, not the Treasury.

Mr. Paletta and Mrs. Solomon, the WSJ authors, briefly outline Mr. Paulson’s objection with the plan. The authors write, “Treasury Secretary Henry Paulson agrees with FDIC Chairman Sheila Bair that the administration needs to take additional steps to help homeowners, but has concerns with some aspects of Ms. Bair’s proposal… Among his concerns is that sharing eventual losses with the government could give lenders an incentive to push homeowners into foreclosure.” Secretary Paulson seems to share a concern I outlined in “When government becomes a bank, anyone else concerned with moral hazard? (part 1 of 3)”. My concern which Secretary seems to share, is that a guarantee may make the crisis worse by putting a new and dangerous incentive structure in place to encourage foreclosure.

As the recession deepens high risk borrowers become even riskier. To keep interest rates artificially low (perhaps as low as 3% ) the government will have to increase the guarantee to compensate. At some point the guarantee will be so high a bank will be better off cutting their losses and foreclosing on a property, selling it at auction, and collecting the government guarantee. It is an important concern that the FDIC should really consider when pushing their plan.

Further I think it is important to note the WSJ article does not address how a guarantee could address the fundamental problem that many homeowners are overleveraged. Without addressing how to manage exorbitant principles that were incurred during the real estate bubble, I do not believe the plan can be considered a comprehensive policy that creates an effective market structures.

The article also did not elaborate on any key details for government restrictions on restructured loans, which may make this program even less effective because it adds cost and reduces flexibility.

I am pleased to see that Secretary Paulson is insisting we do not hurry into a program because it sounds advantageous politically, but rather insists on creating policies that create effective market structures.

When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 2 of 3)

Since the last debate Senator McCain cannot stop talking about renegotiating mortgages. I am partial to a plan that is in the likeness of the Home Owners Loan Corporation (HOLC), although I should make it clear this is not the Senator’s idea. Thanks belong to FDR (or one of his brilliant advisors) and Chairman Bernanke who happens to be a great depression scholar. Bernanke and Secretary Paulson reintroduced America to this concept over the summer, way before McCain claimed it for his own in the last debate at the end of October. The details of any government backed plan have not been released but this article will take a look at how a potential program could help the current crisis.

Part 2 - Home Owners Loan Corporation

A program like the HOLC has two core principals: (1) A government lasts forever, which means they can wait forever for a return on investment; (2) A government has easy and inexpensive access to capital by way of issuing treasury bonds. Putting these two principles together the HOLC worked by issuing long term cheap government debt, and then used this capital to buy out troubled mortgages, taking the place of a private bank. The terms of the restructured mortgages were also extended (allowable by principle 1) spreading out the mortgage amount over more payments, which reduced the monthly payments substantially. [1]

Access to inexpensive capital will help the general liquidity crisis the banks are experiencing and allow homeowners access to a fixed rate. One can easily imagine a government backed program that can offer even the riskiest lender somewhere around a prime rate because the cost to obtain capital is so low. Today’s 10 year treasury sits just below 4%, add approximately 3 points for administration costs (I think this may be underestimating for a government run program of this size) and you have just about today’s Wall Street Prime. With this in place we can get homeowners out of their high adjustable rates and down to a reasonable 7%.

To address the problem of the overleveraged troubled borrower outlined in my previous installment, the term of each loan must be a cornerstone of the program, which may be politically sensitive. The 1930s HOLC program extended terms from the common 10 years to one more typical of today’s market, 25-30 years. As a core principle of this program the restructured mortgages must increase the term of the loan to reduce monthly payments. By extending the term the inflated principle can be spread out over a longer period, reducing monthly payments to an affordable level, keeping borrowers in their homes, and allowing the real estate market to turn around. I can only assume today’s 30 year mortgages would need to be extended to a minimum of 50 years, possibly longer depending on an applicants mortgage amount. The increased term makes these inflated prices affordable on a monthly basis avoiding foreclosures. I anticipate political sensitivity because a 50 year mortgage is a very new concept to most Americans (not all, it has had a limited introduction in very expensive markets, New York and California). It brings with it the reality that mortgages may be passed down through generations and a new time horizon for owning a home that many Americans may not be comfortable with. I think this John McCain is not telling Americans about this important concept because he cannot sell it in a 40 second news clip.

A new HOLC is a good idea but we all have to recognize it will take time and have some upfront government costs. The administrative cost can (ands should) be tied up into the issuance of each loan but this is a massive government undertaking and should not be taken lightly. As of September 4 million American Homeowners, many more may be making payments but barely staying above water. These troubled mortgages will need to be reassessed through this program. The loans will have to be underwritten again, and a reasonable long term debt service established. Individual attention will need to be given to each applicant which prevents a cost saving pre-packaged design. Since a general form cannot be created, loan officers with a fairly high skill level will be needed to run this process (lucky enough there are a lot of bankers looking for work right now). Dare I suggest Freddy and Fannie could do the work because they may have the infrastructure. If this were to occur they would have to act as government agents, restricted from profiting from the new loans while the government takes on all the risk otherwise we will create another bubble (see “Truly understanding the credit crisis and why it isn’t all Greenspan’s fault). The ideal would be an organization that acts solely in interest of the government, (is the government) and with the goal of structuring loans that protect taxpayer capital. Government once again becomes our bank. Sound expensive and complicated? – It will be, but at least it might work.

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[1] I have just recently started educating myself on the details of the HOLC process. I do not claim to be a great depression scholar but this site was great for a pointed description and the Washington Post had a great article back in the spring.

When Government Becomes a Bank, Anyone Else Concerned With Moral Hazard? (Part 1 of 3)

As the treasury continues to figure out how to use their $700 billion, there seems to be a real conversation about how to directly assist troubled mortgage holders. I have yet to hear an effective structure for any of these programs, and have heard even less about averting a moral hazard. When John McCain talks about economics the only thing he can be sure about is the need to “renegotiate mortgages.” His speeches frame a program that sounds roughly like the Home Owner’s Loan Corporation (HOLC), a great depression era government program, but the details of McCain’s plan are more than a bit scarce. A different approach was outlined in yesterday’s New York Times. This Treasury/Bush plan seems to be more of a loan guarantee program. This 3 part series will explore both of these options in Parts one and two, then explore the moral hazard issue in part three.

Part I – The Loan Guarantee

There are some fundamental flaws in the loan guarantee program outlined in the Times article. The guarantee promises a government backing after a loan is “modified according to standards established by the government”. A guarantee will add collateral to a loan, and should in theory reduce an individual’s risk factor, thereby inducing the bank to restructure at a lower rate. But the guarantee does not address a core issue, a sub-prime lender will never be able to afford a restructured payment because the borrower is over leveraged. In a loan guarantees the borrower still carries all the principle debt. In this lending climate any successful program must address the issue that the typical troubled mortgaged holder is overextended and must deal with some management of their unaffordable principle.

First we must identify what it means to be over leveraged. In December of 2007 Henry Paulson identified this as a key problem and suggested abandoning rate based initiatives because they would not work, recommending instead to freeze teaser rates to buy time to create a comprehensive policy. Secretary Paulson understood that an over leveraged borrower can only afford their principle based on a “Teaser Rate”. The borrower had planned on refinancing their mortgage before it adjusted to a higher rate, which allowed a borrower to afford a much higher principle in the short term. If the borrower planned on continually refinance before the mortgage is adjusted they could perceive this teaser rate to be the long term rate of their loan. This borrower was able to obtain this mortgage based on extremely lax underwriting standards which aligned the lender’s incentive structure to support this reckless mortgage planning. My analysis in “You would have been an idiot not to take a teaser rate, adjustable mortgage in 1999” showed how tempting it was for someone to become over leveraged using the above described method.

A loan guarantee will not help the over leveraged mortgage holder by reducing their principle debt burden, the core problem noted above. The best a guarantee program can do is effect the interest rate. To be effective the guarantee must be able to lower it enough to make debt payments affordable. I think a suitable benchmark target rate (and Henry Paulson would agree) would be the last rate an over leveraged borrower could afford, which was likely a teaser rate of approximately 3%. With a bank’s cost of obtaining capital around 5%, (the current LIBOR rate) I would argue it is impossible for a sub-prime applicant to receive 3% in today’s market, even with a government guarantee.

As LIBOR begins to come down a guarantee becomes more feasible but it seems that the risk level of a sub-prime borrower will only become worse. The guarantee will have to overcome all market risk factors that are working in the opposite direction of keeping a rate artificially low. This means the government will have to take on more risk to induce a low rate as: (1) housing prices (the asset the mortgage is secured against) continue to fall further (dropping 14% in the spring), (2) unemployment continues to rise and (3) recession fears continue to deepen. It would be impractical to assume given these factors a risky borrower would be able to obtain a rate anywhere near their former teaser rate, even with government backing.

I also want to note a guarantee may actually hurt the foreclosure problem by putting an incentive structure in place for more foreclosures. A guarantee does not prevent the bank from foreclosing on a property and selling it at auction. I present the following scenario: A bank will restructure the loan, the homeowner will still default because they cannot afford debt service on such a high principle (as shown above), then the bank will still foreclose, capture the government’s guarantee and auction the property for whatever it might still be worth. The government backing gives a higher payoff for foreclosure. This additional reward for foreclosing may provide enough incentive for a bank to cut their losses.

The Times article was light on detail, but it seems the guarantee will be working against market forces that are making these borrowers more risky and do not provide a solution to reduce an unsustainable principle. Any way this program is designed the targeted troubled homeowner is still without a home. Not a very promising solution.

What is LIBOR anyway? And What Is The Scary Message It Is Sending?

I attended a seminar last week aimed at educating small business owners about how to access debt in today’s market. One of the speakers at this meeting was a regional manager for a local bank, in charge of overseeing commercial loans for several of the industrial sectors of New York City. After you read the following article you will hopefully understand why I gasped when the banker responded “I don’t really know” when asked, “Can you please explain what LIBOR is, and how it is shifting your bank’s business decisions for commercial loans.” I will do my part to educate everyone on what this term means, and explain why this banker REALLY should be paying attention to it.

LIBOR stands for London Interbank Offered Rate. It is the interest rate charged when large financial institutions lend to each other. The rate is fixed daily by the British Banker’s Association through a survey of major banking institutions. This metric is usually not part of dinner table conversation of anyone working outside of the finance sector but it has seemed to take on a new importance as evidence in the above story where a small business owner was suddenly concerned about it. Since it is set by a daily survey it has come to reflect a market driven benchmark for the fear banks have when lending to each other and as such an important new economic indicator.

My interest in this marker started early last spring as I started to see an uptrend at work in bank commitment letters using LIBOR for commercial loans. Simultaneously it seemed to be thrust into mainstream media. Traditionally commercial (and home) loans use the Wall Street Prime Rate, which is closely tied to the Federal Funds Rate. As Mr. Kirchofer accurately points out in his article outlining the financial crisis, the Federal Funds Rate is a fundamental tool the Federal Reserve uses to execute monetary policy in the U.S. But by the spring of 2008 it seemed that the Federal Reserve was loosing its grip on making effective changes in the market. As pointed out in a May New York Times article by Julia Werdigier. “…when the credit market seized up last August, many banks, concerned about their own financial positions, were no longer willing to lend money to one another. As a result, Libor shot up, even as central banks like the Federal Reserve tried to drive borrowing costs lower.” The disconnect between the Funds Rate and LIBOR adds a new dimension to this crisis.

This frightening trend has emerged because LIBOR, in this financial climate, reflects a bank’s real risk. Banks rely on each other to meet day to day cash calls with short term lending (1-3months) and the interest rate for this lending is again the LIBOR. LIBOR on the rise is an indication that banks are hording their cash to meet only their cash calls and see lending to other Banks as highly risky. Then, just as a classic bank run will work, this perception of risk to lend to other banks is a self fulfilling prophecy. A bank will not lend to another for fear of the lendee becoming insolvent, but that in tern makes the lendee insolvent.

During this past summer, as 100-year old financial institutions met their demise, this problem became much worse. The LIBOR stayed almost unchanged after the Fed and central banks around the world coordinated a global cut in interest rates. Bloomberg news reported in an article today that the Federal Reserve is considering cutting the overnight rate to 0%! The Fed’s mechanism seems to be loosing its effectiveness with each passing day.

Compounding this problem is a new fear of turning to the Fed as a lender of last resort. This can best be seen through AIG, who after receiving a $85 billion loan in September saw their already embattled stock value plummet from about $22/share to about $2/share (as of the time of writing this article AIG is still around $1.40/share). The point being that the Federal Reserve is becoming a non-option, a white flag of distress that banks cannot afford to use. As a result the only way to solve liquidity is now out of the hands of the Federal Reserve’s ancient tool belt. LIBOR is the new metric for this crisis, at least for the time being.

There is light however at the end of this tunnel. Central banks around the world have seemed to realize the importance of these inter-bank loans and have started to guarantee shot term loans between banks. As a result the LIBOR rate has seemed to have stopped its upward acceleration in the last week. It is a dim but hopeful light that there is an easing of the liquidity crisis. When things go back to “normal” the funds rate will probably come back into play, but for now everyone should be keeping their eye on LIBOR.

Truly understanding the Credit Crisis, and why this isn’t really ALL Alan Greenspan’s Fault.

I have had a lot of interactions over the past few weeks with people just baffled by what is going on in our credit market. I dare not claim to have all the answers (I don’t think anyone would) but this is a brief introduction to what the credit crisis is, how it happened, and why Alan Greenspan really is not the one to blame.



To really understand how the economy of the United States could come to its knees in a few short months there is one fundamental issue to understand, what is a mortgage backed security, and how did that shift incentives in the banking industry.

The key to this crisis is a misaligned incentive structure for banks. In a traditional bank loan, the lender’s balance sheet reflects the value of the asset it is lending money out for. This lays incentive groundwork for the bank to make good (safe) loans which they are confident will be paid in a timely manner because their bank is on the hook if the loan goes into default. In a Mortgage Backed Security a portfolio of loans will be assembled and then sold to a third party. These Securities are best described as a well diversified mutual fund that only contains real estate. Similar to a stock mutual fund a Mortgage Backed Security includes properties from all of the U.S. and with that comes inherent diversification. Property value in the northeast can go down but value goes up in the southeast, the overall value of the portfolio stays the same. It seems on its face to be great for the bond holder; however this structure removes the incentive structure on banks to make good loans. The bank now has the incentive to just make loans since they will eventually package these loans and sell them to a bond holder. The bank is now in the position to be completely risk adverse. To illustrate by example:

Oregon Home Owner gets a Loan from Local Bank A. Local Bank A then takes this loan, and sells it to an Investment Banks like JP Morgan in exchange for the principal amount plus some premium. The Local Bank has now cashed out of the risk. JP Morgan buys up mortgages like the one from Oregon Home Owner from all over the country and put them in one Mortgage Backed Security. This Security now has a risk value with a set return, all backed by assets throughout the country. The Security is then sold to a bond holder, ironically enough it is often another (or even the same) Investment Bank.

This process works, without fail, as long as the value of the underlining properties continues to rise, even with a few defaults in the portfolio the overall diversification yields a comfortable safety net. The lynch pin in this dream of an economy was inflated home prices. At some point (roughly summer 2007) Americans ran out of credit, and could no longer support the ever rising U.S. home prices. Now people are stuck in high risk adjustable rate mortgages, (how they got there is best understood in my previous article: You Would Have Been Stupid Not To Take A Teaser Rate, Adjustable Mortgage in 1999). Diversification does not work if the home value of every home in the U.S. starts to depreciate. Cue the snowball effect! When homes stop appreciating, homeowners cannot access the equity in their homes through a refinance. In tern they cannot make their now hugely inflated monthly payment on their adjustable mortgage, and even if they were making payments, their home is now worth significantly less with each passing day. As a result, EVERYONE stops paying their mortgage. The securities fall one by one, and investment banks are left with properties that no one can afford to buy.

The worst part of this story is that as banks start bleeding funds because people stop paying their mortgages, the credit market freezes for the functioning economy. Businesses with working credit lines suddenly see them disappear. Not because of late payments, just because the banks can’t afford the risk of laying out any more money. In tern the company does not have working capital for raw materials to convert into finished products, and the economy overall grinds to a halt.

Where does Alan Greenspan fit into all of this and why do we suddenly hate our beloved Fed Chairman? Mr. Greenspan is blamed for not putting a stop to this madness, and in some respect he is to blame. The Federal Reserve does claim responsibility for regulating banking institutions, which created this wonderful concept of a mortgage backed security. But before we string up Mr. Greenspan, the primary role of this banking regulation is and should be done by the U.S. Treasury. The Fed should return to their first true love, inflation control. Further Mr. Greenspan is taking the brunt for the real criminal the Securities and Exchange Commission. The SEC, who is charged with the integrity of the U.S. markets, were in love with deregulation but have never heard of a market incentive. So Alan, I think you should share your blame with Christopher Cox, William Donaldson and all his associates that preceded in the position since the early 90s, and for god sake take a nap!

You Would Have Been An IDIOT Not To Take A Teaser Rate, Adjustable Mortgage in 1999.

A lot of attention has been given to the wayward homeowner and how they would suffer. No one really touches the question of how they got into their situation.

Starting in the 1990s there was a simple, ingenious game to play in the American housing market. Home prices were increasing at such a startling rate that someone could essentially live for free by continually refinancing their loan to adjust to a higher land value. Consider the following example:

I buy a home for $500,000 in a market that is appreciating at a rate of 10% a year (think that’s not possible?). I lock in a “teaser rate” of 3% for 2 years before it adjusts to 2 points above prime. My monthly payment on this loan for the first 2 years will be about $2,000/month (assuming 10% down and a 25 yr amortization for the payments in the first 2 years). After 2 years when my adjustable rate mortgage adjusts, I will have paid a total of $48,000 in debt service. At this point my home’s value is $605,000 (10% compounded over 2 years). I will refinance, take the 105,000 difference, and pay myself back for 2 years worth of mortgage payments. Then have a new loan with a new teaser rate. Then the process repeats, roughly every two years until the US Economy collapses.

Now some would say these are the very people our bail out plan should not be helping, I beg to differ. First you cannot blame people for responding to incentives, if this structure exists people are going to take advantage of it, they would be stupid not to. Secondly most people involved in this process fundamentally trusted that real estate values could only go up. And they were right for about the last decade and a half. If they were buying a house during the late 80s they would have known better, but no one is perfect.

When looking at the foreclosures that are occurring around the country it is worth looking at how we got here. The take away is the mentality of the person in the above example. They will never actually OWN their home, they continue to refinance forever. This short sided thinking is the real crisis in America. This person thought their home could never depreciate and I can bet they never thought their home would be in foreclosure. To truly overcome the crisis we need to shift to conservative thinking: budgeting, saving, financial planning, and pride in living within our means.

On a final note, this purposely does not address predatory lending. There is not much to address this scenario other than the failure of our education system to give a person the tools to know how to make the right life decisions. The story is shorter but the conclusion is the same, the US needs to make a fundamental shift in mentality, take control of their finances, learn about the risks they take, and live within our means.