Moral Hazard: “The Role of Government in the Housing Finance Market”

So says Larry Wall, “a research economist in the Atlanta Fed’s research department”:

…the lesson I wish we could most learn is that it is very costly for the government to subsidize an activity by guaranteeing loans as a way of lowering the cost of borrowing. Government guarantees are very seductive in the short run. It looks like something for nothing. The government provides a subsidy to borrowers, which encourages the borrowers to do something deemed socially desirable. The borrowers obtain an immediate gain. So often do the people selling the goods, such as in the housing industry—the homebuilders and the realtors. Yet this subsidy can be structured in a way where it shows no cost to taxpayers for long periods of time.

But eventually the socially desirable activity becomes oversupplied, and the borrowers take on too much debt. Then the seemingly costless government guarantee becomes extremely costly for taxpayers as the government makes good on its loan guarantees. Moreover, it often turns out badly for many of the borrowers as they struggle to support excessive debt and/or they default on their debt, ruining their credit ratings and, increasingly, their access to other things such as jobs. Thus, I would argue that any activity that we agree should receive government support should receive that support with an upfront grant of government money rather than through debt guarantees. Moreover, I would hope the support would be structured in a way that does not encourage people to take out larger loans.

via The Role of Government in the Housing Finance Market.

Now, that all sounds fine on the surface; however, and correct us if we’re wrong, but we didn’t hear any focus being placed on the Wall Street investment bankers who gave tens of billions of investor’s dollars into creating mortgages via more than shady practices where the GSE’s are now forcing those banks to take back many loans that did not meet the GSE’s clearly stated standards. In other words, it appears that the only thing that is discussed in the interview is that the GSE’s are a moral hazard rather than that the Wall Street banks/investment houses were exceedingly under supervised by government regulators.

There are former Wall Street insiders who were very high up at the time who’ve gone on record as saying that nobody was looking over their shoulders, even though their toxic tranches were being rated AAA, and that they simply took huge advantage of that. So, the moral hazard was in the lack of proper regulation and oversight and not simply the way Fannie and Freddie were designed.

So, while it may not be the best public policy to have designed and used Fannie and Freddie the way they were, it is wrong to place all or nearly all of the sins at their doorsteps and the solution lies more in proper regulation and oversight than in simply further privatizing. Agree? Disagree?