Finance
Moral Crisis
The Chairman of the Federal Reserve Bank is once again out front leading the charge to destroy the US financial system. Inflation is alive and well (unless you happen to live in that fantasy world called Coreland) and the currency is in the tank. Perhaps we can forgive the rise in grain prices as ethanol, a prime culprit, was the creation of our wonderful Congress. Recently, however, Bernanke has moved well beyond his disdain for sound monetary policy by jumping feet first into the sub-prime/securitized asset fiasco. Joining with Treasury Secretary Paulson, Bernanke last year advocated reducing interest rates on sub-prime mortgages to those borrowers 'in trouble' and subject to foreclosure. A number of analysts and commentators pointed out the significant moral hazard such actions would put into play: a bail-out of borrowers who borrowed more than they could service; a bail out of borrowers stuck with properties they intended to flip but had insufficient capital to carry through a downturn; a bail out of borrowers who covered their ears so not to hear the adage 'if it sounds to good to be true...' ; a bail out of lenders (banks) who would be required to provide liquidity to various other entities holding sub-prime mortgage paper and CDO's; arbitrarily changing the terms of legal agreements without the consent of all parties involved; causing potential serious harm to third or higher parties involved in derivative transactions against other investors closer to the original mortgage. The list goes on but many believe the end effect would be to raise future borrowing costs as lenders adjusted their pricing to reflect the new reality that a loan is only to be considered contractually valid when times are good and that terms may be changed adversely at a later date to provide relief to the borrower at the expense of the lender.Moral hazard was not sufficient for Mr. Bernanke as he apparently prefers to see a moral crisis. In a speech he gave to an audience in Florida yesterday Mr. Bernanke proposed that in addition to other measures, lenders should also reduce the principal outstanding.That's right - Bernanke thinks the most irresponsible borrowers should be rewarded not just with a lower interest rate (like one fixed at their introductory ARM teaser rate) but they should also be forgiven whatever negative equity their transaction has created. Have a $300,000 loan on a house now only worth $250,000? Big Ben thinks your lender should give you a mulligan either give you $50,000 against a new loan with another lender or rewrite the current loan to reflect a new principal due of $250,000. Beyond the impracticality of this idea - what on earth could be the justification?
To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare. The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions. With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home. In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.So lets try to understand this. Bernanke is trying to justify cutting the outstanding loan principal because this will somehow give 'incentive' to stay in the home? Or if the principal is reduced far enough, there might be some positive equity the homeowner could borrow against!?! This is patently insane. -more-
