The great moral hazard fallacy

I would like to spend a few minutes advancing an argument against the number one "reason" policy makers are touting against mandatory principal writedowns for mortgages. Note that pretty much all economists agree that this is the easiest, cheapest, and most effective approach to solving the current housing crisis, and that if structured in such a way that lenders still share the upside when houses eventually get resold down the road, the cost will be cheaper still.

But what they all say - and what many people get upset about - is the idea that by doing so, one is helping careless home buyers who have "taken a risk" and "should now pay for it" rather than "get rewarded" through a writedown. It's simply unfair, or so goes the argument.

Absolute, utter, complete hogwash.

Not only is this nonsense, it's dangerous nonsense, because it sounds "right" so it's very convincing. Sort of like a post-hoc fallacy.

Let me explain why. It really won't take long... the simple reason is that... drumroll please...

The homeowner doesn't gain from it!

I am now going to wait patiently for you to cease from your paroxysm of hysterical laughter. No worries, go ahead, enjoy it, there is a lot of research pointing to the health benefits of a good belly laugh ever so often.

Ready?

Good. Let's proceed.

The basis for my argument is simple: the one and only person that has gained from the inflated price at which the house was originally sold is - this should not come as a great surprise to you - the seller.

That's the guy that pocketed the inflated gain. That's the guy that got money on paper converted into actual paper money (I love bad puns; this one was for you fiat money haters).

The side that will lose some money in this equation is not the buyer, but the lender. They are the ones that completely ignored asset valuation and risk management practices and lent money at much, much higher valuations than the underlying assets were ever worth - even though they knew better. Brent White in his excellent piece entitled "Underwater and Not Walking Away" (Google it, or visit my previous posting on the topic), explains it a lot better than I ever could:

At a basic level, sound underwriting of mortgage loans requires lenders to ensure that a loan is sufficiently collateralized in the event of default. In other words, in appraising a home the lender should ensure that the loan amount, at the least, does not exceed the intrinsic market value of the home.
As discussed above, a textbook premise of economics is that a home’s value, even an owner occupied one, is “the current value of the rent payments that could be earned from renting the property at market prices.” As such, historical home prices have hewed nationally to a price-to-annual-rent ratio of roughly 15-to-1. At the peak of the market, however, price-to-rent ratios reached 38-to-1 in the most inflated markets, and the national average reached 23-to-1. If personal responsibility is the operative value, then lenders who ignored basic economic principles (of which they should have been aware) should bear at least equal responsibility to homeowners for issuing collateralized loans that were far in excess of the intrinsic value of the home.

So. We have the seller on one side, who has made some nice moolah, and the bank on the other, having lost that same amount of moolah. Yes, I am simplifying, in reality many loans got sliced and resold but the principle of my argument remains the same, so I will conveniently gloss over these details.

I ask you to note the mysterious absence of the buyer in this equation.

I am not going into the argument for strategic defaults (Google it too), but they all seem to fail to hone in on this point. Let me state this again: the buyer has not really been a participant. As is typical in a real estate transaction, the money goes straight from the buyer's lender to the seller, and the buyer signs a promissory note promising that they will do their best to repay that money to the bank, with some interest tacked on. It used to be that buyers had to actually put some money on the table too - you know, those pesky down payments - thus giving them skin in the game, but lenders decided at some point to not only give sellers a lot more cash than could ever be justified for the asset, but cut out the buyer's participation entirely by not demanding down payments from them, effectively turning them into... can you guess?

Yes, renters.

Their thinking: our middle man - that buyer - will flip the thing in a couple years and we'll make decent interest in the mean time on this "low risk" investment. And that's what the good lenders thought, the one that actually kept the loans on their books. The vast majority simply repackaged the whole thing and resold it, making their money back right there and then with some nice fees attached. Anyway, that sordid part of the tale is also far too long to get into in this post.

But note that the buyer did not, at any point, actually get any money. They moved to a new house, and are paying a mortgage. Now they are paying a mortgage that makes no sense to pay anymore, hence strategic defaults and the whole nasty cycle that we are experiencing due to negative equity. Also note that the subprime folks have been mostly washed out by now; the crisis is now squarely in the prime arena. The people we're talking about are not speculators, they are the upstanding middle-class citizens who are the backbone of this country.

Now here is what happens if you write down principals: the buyer still isn't getting any money. Really, they are not. The seller already got it, and made out with it; you can't catch those folks anymore, they are long gone. Actually, most of their profits have probably been "reinvested" along the way in speculative real estate deals, where again one bank transferred money to another with a middle man being that seller who is now the buyer using those quick gains to try and make more quick gains. I wish someone actually tallied up how much of those paper property value profits were actually simply the same money constantly moving between financial institutions determined to make as many fees as possible on the process of moving those digits from one institution to the other using middle men "sellers and buyers". That would a fascinating study, I'm sure. Sort of like the paper profits of the dotcom era.

But back to my point. The buyer hasn't made anything. The don't suddenly get all this money in their bank account to spend on lavish vacations and new cars. They never see any real benefit from it, because the house will never be worth enough for this to register in their bank account - and if it is, then by having a clawback provision in the mandatory writedown concept I've described above ensures that this does not happen. The seller already had their cake, and ate it too. That monetary benefit is already long gone.

But what will happen is that the buyer now has an incentive to keep making payments, making the loans perform. The lender will "lose" money, but it's money they already lost when they gave it to the seller. It is not money they can realistically recoup from the middle man - that buyer - because although many of us our sheep, we are not that stupid of sheep, and many folks are making the decision not to pay double the price of anything just for shits and giggles. So the bank ain't seeing this cash back, not because the buyer is being mean, but because the guy who ripped the bank off - that original seller - already took the money and ran.

Thus the moral hazard argument is misleading. If any moral hazard is to be discussed, it's the one that applies to sellers who sold before the crash, managed to somehow be smart enough not to buy back in, and are now sitting on a pile of cash they got for free (because the buyer's lender threw caution to the wind by financing an asset at inflated prices). But guess what; those folks were not morally corrupt at all, rather they were smart and benefited from reading the market properly. Just like those folks crying "moral hazard" on Wall St, in fact... interesting, no? these smart sellers will tend to view this as having been real lucky, and gotten a once in a lifetime financial opportunity. Some of them may be spurred on to start a business with some of this money. Some of them might spend it recklessly, of course. Who knows? the point is that this part of the deal is long ended.

No buyer that "benefits" from this, however, will ever see this cash. No way, no how. All they will "gain" is a sense of fairness, where they are making a normal payment for their house, and will still be in worse shape than other buyers, because they will not benefit from any appreciation unless houses magically top their previous peaks (in 40 years, maybe).

This is so obvious I am wondering who, exactly, is advancing the moral hazard argument. Oh, wait...