Government bailout: Fair or not for homeowners?

[Ginger]

Of course Im home watching the evening news and the reporter asked whether or not it's fair for the government to bail out Bear Sterns and not reach out in the same manner to homeowners.

What are your thoughts?

[The Honest Dollar]

This is part of a really long reply I wrote on the other thread about Bear Stearns:

Originally Posted by The Honest Dollar

The Fed did not bail out Bear Stearns.

What is a bail-out?

A bail-out is "a term used to describe a situation where a bankrupt or nearly bankrupt entity, such as a corporation or a bank, is given a fresh injection of liquidity, in order to meet its short term obligations."

This is not what happened to Bear Stearns, since the Fed did not give any liquidity or money to Bear Stearns. In fact, Bear Stearns sold for less than its headquarters building is worth, and management stake has pretty much been completely wiped out. This means that if anything, the Fed helped along Bear's demise.

What the Fed actually bailed out is the entire financial system.

Bear Stearns (as well as most of the major investment banks) carried significant derivative contracts obligations (in particular credit default swaps). Bear's exposure, i.e. what it has to pay if all of the contracts were executed, was $13.4 trillion - roughly the same as the US GDP. (It wasn't actually at risk to lose nearly that much since the stock market would need to blow up before that actually happened, but that's a sobering number.)

What happens if Bear dies unassisted and no one is left to pick up its obligations? Then it's the buyers of the contract that really get screwed. And some of them probably deserve to be screwed, but not all of them - an en masse screwing will take the market down with the buyers.

Some of the people holding onto Bear's obligations are other banks. If investors believe that these banks will lose what Bear owes them, then they might reach the conclusion that these other banks will soon be insolvent as well, and pull out all their funds. This, of course, is a self-fulfilling prophecy - once investors withdraw, those banks will become insolvent.

So the Fed made a deal with JPM to assume Bear's obligations and keep the market chugging along. Essentially, it did what the government failed to do to prevent the market crash of 1929: take action to remedy a run on the bank.

The Fed did not bail out Bear Stearns.

It had a chance to. It could have provided Bear Stearns enough short- and medium-term liquidity to meet its obligations (which would not be $13.4 trillion - that's just a notional amount assuming, say, the price of all stocks fall to $0, and every put option written by Bear gets executed).

However, the Fed did not do this. And it shouldn't have. It's the responsibility of Bear Stearns to make sure it has a sufficient margin of safety to cover its obligations. Bear can't control what investors think and can't prevent a run on the bank, but it might have taken some precautionary measures by decreasing leverage, reducing risky positions, and improving its own liquidity.

The Fed did not reward Bear for its irresponsible behavior.

I also don't think there's a particular moral hazard here. No existing bank will look at Bear Stearns and think they can get away with anything and the Fed will bail them out. All Bear's story says is that if you massively ignore risk management, the Fed will help your competitors eat you up.

That thread contains what I think is a really good discussion, with excellent comments from both sides of the fence. I especially liked rstlne's criticism of the Fed's action, even though I tend to disagree.

So I think it's incorrect to ask questions like, "Should the Fed have bailed out Bear Stearns?" or "Is it fair for the Fed to bail out Bear Stearns but not homeowners?" - since what happened with Bear was not a bailout.

To the more general question of whether it's fair for the government to bail out the financial sector but not troubled homeowners, I'm still not sure it's a valid question to ask at this stage. The Fed has been trying to bail out the financial sector with pretty desperate measures like deep rate cuts and backing JPM's acquisition. But that's pretty much it's job - to provide liquidity to the financial markets and ensure a proper balance between economic growth and low inflation. Now you can say that the Fed's doing a pretty poor job, but you have to remember it's dealing with a broken system in crisis. What's a better solution? Some say the Fed should just let the whole system crash so we can reboot. But I think those people vastly underestimate what would happen if we let the crisis worsen.

What about homeowners? The Fed has no power to help homeowners directly. It's lowered some key interest rates, but this doesn't help a lot of people who are either locked into certain rates or already deeply in trouble. A rescue would have to come from Congress and the White House. Personally, I hate the idea of a bailout here because I don't think it's critical to the functioning of our economy. Much of the bad debt has been written down already, so companies at the receiving end of the subprime bludgeon are already acknowledging they'll never get their money back and they're moving on. As for the homeowners themselves, I have some sympathy for people losing their homes - but a lot of them just failed to read their mortgage agreements and think about whether they can afford their houses in the first place. The government shouldn't save them from their own irresponsibility. (And Bear Stearns was irresponsible too, but once again - the government didn't save them.)

[The Honest Dollar]

By the way, I think the media has done a horrible job covering the situation. Subprime mortgages eventually led to the credit crisis, but they're ultimately two different problems affecting two different areas of the economy. It's misleading to treat them the same and to think that any government action need to solve both problems.

The New York Times actually did do a great job explaining how the subprime problem arose and why it lead to the credit/liquidity problem in our financial markets. But the article does make it clear that the bigger and more urgent problem now lies with the sickness in financial markets, not with distressed homeowners.

[Ginger]

Thanks for your opinion HD!

Im interested in hearing other thoughts on the situation

[Jeremy]

The media is doing a horrible job in covering this, and it is amazing how it has effectively all been attributed to "subprime" lending. Subprime lending has played a role, yes, but the role is grossly overstated and seems to be the focal point for all of this discussion.

According to the Center for Responsible Lending as of November 2007, there are some interesting stats regarding mortgages, defaults, foreclosures, etc.

Only 14.44% of subprime mortgages were in default.

Difference in delinquency rates between adjustable subprime mortgages and fixed-rate mortgages: 14.7%.

Only 14% of all outstanding home loans are classified as subprime.

64% of foreclosure filings for the year ending June 07 were subprime loans.

Subprime mortgages made without escrow for taxes and insurance: 75%

Subprime mortgages made without full documentation of income: nearly 50%

Those are just a handful of the many statistics, but clearly there is much more to all of this than just subprime lending. If subprime mortgages only account for 14% of all existing mortgages, that represents a very small number of actual subprime foreclosures when looking at the total picture. In addition, less than 2/3 of all foreclosure filings were of the subprime variety, meaning there are plenty of prime borrowers facing the same problems. And, only slightly more th an 14% more delinquencies are reported on ARMs over fixed-rate mortgages, meaning that many people in a traditional fixed rate mortgage can't even make their payments.

When the majority of these loans are made without full income documentation, and don't account for the thousands of dollars required each year to pay property taxes and insurance, you're bound to see problems. Bad business practice, and borrower ignorance is the only way these factors become such a problem.

This is a long way in saying that while there currently isn't a government bailout now, either for lenders or borrowers, using government funds to actually bail out either would not address the problems at hand simply because there is more to it than subprime problems. Of course, all we hear is subprime, subprime, ARMs, etc. when in fact, from a pure numbers standpoint, there are more people who are prime borrowers and in fixed-rate mortgages facing the same problems. So any type of bailout that only addresses this small (albeit problematic) segment of the industry will not provide the assistance that is needed.

The real problem stems from the bad bets on wall street on the growing number of subprime motrgages, but the problems that borrowers face aren't tied to just these types of loans.

[ThePennyMine]

Yeah, I must say that as sad as the plight of the individual homeowner may be, the security of the overall financial system in the United States is more important.