I'm the first one to admit that the mortgage lending mess is too complicated for most of us to grasp completely. But that doesn't mean we shouldn't all attempt to understand the basics--we all bear responsibility for what we allow our government to do, and in this case that means we're all responsible for a massive mess.

Here, then, is an explanation (with viewpoint) for "the rest of us," those of us who don't have a degree in economics from Harvard.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

On this much, most everyone agrees. These are the largely undisputed facts. Where politicians (and some economists) part company is in discerning what should be done to "fix" the problem and ensure that we don't end up here again.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This "moral hazard" generates enormous distortions in an economy's allocation of its financial resources.

There is a solution.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending. [emphasis mine]

Despite the pain that Jeffrey Miron's approach would cause in the short term for you and me and much of the country, it's the only thing that's more than a band-aid. Yes, it will seem to egalitarian Americans to be unfair to poor and some middle-class families. But life isn't fair. And no amount of government Ponzi scheming can create fairness. But once we bought into the fact that everyone deserves, at taxpayer expense, a minimum standard of living, public education, etc., it's a short step to making sure that every man (or woman) can "buy" a house even if the taxpayer ends up buying it for him.

Sorry, folks, there's no free lunch house.

Labels: Money, Political Observation, Social Observation