The Moral Hazard of Regulating Sub-Prime Mortgage Lending

The term "moral hazard" is being bandied about in commentary about the sub-prime mortgage woes currently roiling our financial markets.  Columns from George Will and Irwin Stelzer among many others, warn against the interposition of government bail-outs or federal pressure on lenders to develop rescue packages for failing sub-prime borrowers.  These bail-outs fit the traditional definition of moral hazard as "an insurance problem; when the cost of a disaster is reduced with insurance, people have less incentive to avoid the disaster."

Our federal flood insurance programs are a classic case in point:  those inclined to live near the ocean or gulf or in river valleys prone to flooding would be reluctant to live in these potentially dangerous areas if they had to foot the bill for the effects of floods or hurricanes.  Instead, Big Brother balances the risk on the backs of more sensible Americans, allowing a special form of insurance helping flood victims keep re-building in the face of almost certain future claims.  This raises insurance rates across the board for all of us and actively encourages people to move into flood-prone regions.

A similar rescue plan for the sub-primes is an undeniable recipe for disaster.  Sub- is no idle prefix when used to describe these loans!   Sub-prime mortgages often entail lending to a client with a proven inability or unwillingness to pay.  (Many clients who would appear to have plenty of income to pay their obligations still have spotty payment histories.  This isn't inability:  it is the willful choice to spend their money on something other than their legally incurred indebtedness.)  Many of these loans bypass conventional tests for debt-ratio, and often require little or no down payment.

Why would a lender offer terms to a client who has proven he cannot or will not pay his obligations, or one who doesn't have an invested stake in the collateral?  The simple answer is:  return on investment.

Conforming loans, those written to clients whose debt ratios and credit histories are sensible, currently bring about 6.0% on a fixed 30 year term.  Sub-prime loans are currently priced closer to 10%.  On a 30 year loan for $100,000, the conforming lender expects a return of $115,838 in interest over the full term of the loan.  The non-conforming or sub-prime lender at 10% interest expects an interest return of $215,925 over the full term.  This is quite an incentive!  This is $277 per month in additional interest!

Currently somewhere in the area of 85 to 90% of sub-prime mortgages continue to perform at an acceptable level.  This obviously represents a higher level of default than the lenders can bear.  Lender insolvencies and bankruptcies are the clearest indication that they have taken risk without charging sufficient interest to offset their losses.  Thus the sub-prime crisis.

Now crusaders like Hillary Clinton and Chuck Schumer would have the government require lenders to develop a fund to help those failing to pay their mortgages.   In addition, many unenlightened commentators suggest that the problem is that lenders have been "predatory" and charged usurious rates.  But if the lenders had been charging rates that were actually too high, they would still be in business!  Six of the top mortgage lenders from 2006 are completely out of business, and most of the others are struggling.

Government programs are also being proposed to "bail out" troubled borrowers, thus taking away the incentive to avoid the disaster of default.  With irresponsible borrowers having an additional federal safety net to protect them from their own fiscal mismanagement, their disincentive to pay would only grow.

The dirty little secret of the sub-prime crisis is the fact that sub-prime lenders failed to charge interest rates high enough to offset their expected level of defaults.  Make no mistake: sub-prime lending is going to have borrowers who fail.  Even conforming borrowers sometimes default. Enabling lenders to charge enough to make profitable loans to less qualified borrowers will result in a higher level of foreclosures.  But it will also enable legions of "sub-prime Americans" to realize the American dream of home-ownership.

The capitalist system doesn't insure against failure. Instead, it allows for risk-taking and rewards well placed, but still risky bets.  No amount of Hillary's and Chuck's socialistic thinking is going to create a magic wand to make affordable mortgages available to every American regardless of their ability or willingness to pay. 

It is a noble experiment to give less qualified borrowers the chance to become home-owners and succeed or fail.  So let's allow the chips to fall where they may and let those who can't or won't pay fail. 

But don't hamstring the market by regulating it.  That has never worked.  Esteemed 19th century British economist, Walter Bagehot, in the book, Lombard Street back in 1873, had the right prescription for failing financial markets:  "Lend freely against good collateral at a penalty rate." 

Seems pretty simple: ascertain the real value of the collateral, raise the rates and continue making loans.  The sub-primers that succeed will subsidize those that fail and perhaps move on to more conventional financing once they have proven their ability and willingness to pay.

Ralph Alter is in the mortgage lending business.