In recent weeks, President Obama has outlined his strategy for revitalizing the middle class and the housing market. Initially, he engaged with CEOs to address middle-class challenges. More recently, while speaking in Arizona, he proposed government guarantees for securitized mortgage packages—a bold approach, indeed.
According to Reuters, “The core of Obama’s proposal involves winding down mortgage finance giants Fannie Mae and Freddie Mac, which own or guarantee over half of all U.S. home loans and play a crucial role in facilitating capital flow to lenders and borrowers.”
The administration aims to replace these entities with a system where the private sector purchases home loans from lenders and transforms them into securities for investors. At first glance, this appears to signify a move towards reducing government intervention and the market distortions it creates in housing. However, as is often the case, intervention can lead to new complications—most notably, moral hazard.
“The government would still play a role in housing markets by insuring or guaranteeing those securities—at a cost to investors.”
Understanding Moral Hazard
Moral hazard arises when a party insulated from risk acts differently than if they bore the full brunt of that risk. For instance, someone with auto theft insurance may neglect security measures since the financial consequences of theft fall on the insurer.
Government bailouts—be it for lenders or borrowers—give rise to moral hazard; they foster risky lending and speculation, as parties come to believe they will not face the full extent of losses.
Recall the Savings and Loan crisis from the 1980s? The U.S. government ultimately incurred approximately $125 billion in costs when over 1,000 savings and loan institutions collapsed. This crisis was rooted in policies established during the Great Depression, specifically the creation of the Federal Deposit Insurance Company (FDIC) and the Federal Saving and Loan Insurance Company (FSLIC). When these warranties were initiated, borrowers and lenders became less concerned about potential losses since the government would shield them. The aftermath of the Savings and Loan crisis only further entrenched the moral hazard, setting the stage for the subprime lending collapse. Obama’s latest proposal could potentially spark another bubble in the housing and mortgage markets.
Socializing Losses: A New Approach
By securing mortgage securities, the government may inadvertently encourage risky lending practices among banks and speculative behavior among investors. Banks might become less discerning about whom they lend to, knowing that the loans will be securitized and sold off. Likewise, investors might pursue these securities with enthusiasm, buoyed by the government’s safety net.
Once again, we see a system where it’s a “heads, I win… tails, you lose” scenario, enabling banks and investors to reap significant profits while shifting the risks and losses to taxpayers. It may take years for this to culminate in a crisis, but history suggests it’s inevitable.
In the meantime, expect a new housing market boom, exactly what governmental agencies and the Federal Reserve are striving for. Rising home prices will help alleviate underwater loans, inspire a construction resurgence, and invigorate the economy.
Notably, our associate Paul Rosenberg at Free-Man’s Perspective recently pointed out that through quantitative easing, the Federal Reserve is purchasing approximately 130,000 houses monthly—totaling around 1.43 million since initiating its mortgage purchasing program in September 2012.
Beyond the Treasury market, the housing sector is one of the most manipulated and propped up markets. Without the influx of government funds, housing would be more affordable for many families. Instead, Obama’s plan escalates home prices, invites speculation, and encourages consumers to take on mortgages they may struggle to repay.
Certainly, we will search for investment opportunities to capitalize on the impending price surge and will keep you informed on our findings.
Sincerely,
MN Gordon
for Economic Prism
Return from A New Plan to Socialize Losses to Economic Prism
