subprime crisis and moral hazard

In this morning’s Washington Post, there is an article entitled “Paulson Outlines Mortgage Aid Plan”, which provides some details concerning the Bush administration’s mortgage-relief plan. Today’s Wall Street Journal has an editorial about this plan entitled “No Bailouts for Borrowers”. The WSJ article correctly points out a very important unintended consequence of what is clearly a well meaning but misguided public policy; that is, that sometimes the medicine can be worse than the cure.

The proposed intervention would take us down all kinds of slippery slopes. One must consider that if this plan or some variation of it actually gets implemented, then it may very well prospectively create problems in terms of availability and affordability of mortgage financing in the U.S. economy. Investors who purchase mortgage-backed securities will rationally price in the political risk of future interventions, which will in turn raise the interest rates offered for new mortgages. While Secretary Paulson insists that this will not be a taxpayer-financed bailout, an important aspect of the plan has state and local governments acting as financial intermediaries in that they would use their bonding authority to effectively enable distressed homeowners to sell investment grade tax exempt bonds. There is no free lunch; if state and local governments use up debt capacity in order to provide this funding, it will limit their ability to issue bonds in the future on favorable terms. Finally, as the WSJ article points out, there is also a serious moral hazard with the Bush administration’s mortgage-relief plan, in the sense that “…the federal government would set a troubling precedent and encourage irresponsible behavior in the future by bailing out homeowners (and, indirectly, lenders and investors).”

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