Irrationality Should Not Be Rewarded, and Certainly Not Bailed Out

Just a quick note – I’m in my office late tonight and I am listening to one whiner after another on CNBC talking about “helping the homeowner.” Additionally, there was an especially painful 3 hour+ session today where a Congressional Panel asked Bernanke and a few other fellows involved in the Bear Stearns “rescue” or “bailout” (depending on what side of the political spectrum your steam blows from) ad nauseum questions that have already been asked before. What a horrible waste of time.

Let me summarize the “crisis” for those watching at home:

1. stock market crash ruins millions of boomers’ dreams of extremely early retirement

2. Greenspan lowers rates on borrowing money to juice the economy (he used other words – never said he wanted to “juice” the econ)

3. Millions of Americans either take out equity loans and spend more money than they could ever pay back or they buy more house than they could afford using the always foolproof investment thesis that they could sell their home easily for a higher price in 6-18 months

4. Lenders lend to people who would not normally qualify for loans, who put 1% down, and have false income stated. Of course, these people GLADLY take the money (oh they felt exploited I’m sure). Interestingly, many of these loans are adjustable rate loans – the thesis behind this decision is that borrowers are relatively sure (and their broker I’m sure reassured them) that they would be making more money in the future and that the value of home would rise and rates would stay low – again, another thesis which is so well thought out (probably in the 10 minutes before the App was filled out).

5. Eventually, you know what hits the fan. Mortage rates climb, and now our homeowner, Mr. Bling, who just spent $50k on a kitchen, suddenly can not afford the adjusted mortgage (pawn a Subzero anyone?). More and more people are late, some foreclose, some commit bankruptcy. Lenders, worried about their exposure, tighten their lending standards (to levels not nearly as stringent as past requirements such as 20% down and income/debt ratios below 35%). New buyers with shaky credit and poor income can’t get loans.Ergo, they can’t make offers. Ergo, the market freezes up.

6. The fed tries lowering rates – too late – now that owners of mortgage bonds see the risk, they keep the market rates higher on long term bonds so fed easing does not affect mortgage rates as much as the crack er…cheap money addicts would like. Lenders keep their tight lending standards so buyers drop prices to entice the limited number of buyers (I would guess 3 buyers for every 10 sellers). Prices continue down.

7. With increased risk, investors were less willing to buy mortgage bonds at full price. As these values dropped, it affected balance sheets of many firms who use many of these bonds on the asset side of their balance sheets. As the asset values dropped, the asset to liability ratios of many companies dropped which made their creditors nervous (if you lent someone a LARGE sum of money and they guaranteed their bank account to back your loan, and then suddenly that bank account value was halved, you would be a nervous lender wouldn’t you?). Then some companies were forced to sell assets to raise capital to make their lenders happy – or raise new money from stock or bond issuance to raise capital.

8. Some companies had levered themselves so much that when their assets dropped 5% they lost all of their equity (this is how your local bank works – quick example: the bank has $10 million in deposits – it lends out $100 million. The bank has $110M in assets ($10M cash, $100M loans receivable) and $100M liabilities so the “equity” in the bank is $10M. If the value of these loans drop (either through devaluation or default/foreclosure) by 10%, or $10M then 100% of the bank equity is GONE. This was Bear Stearns Problem. Banks are regulated by the Fed on how much they can lend but investment banks are not.

So now we are where we are. Companies are going down – just as regular people who took too much risk are going down. This is natural – as I said in a previous post- the reason that people can now afford a house more then last year is because the imprudent are getting punished as they always do – eventually. Now people are clamoring for a government bailout of basically, everyone and everything.

Is it really bad if someone lost their house and had to rent? Maybe you feel so – what about the person who saved money for a down payment, and will not overpay for a house out of prudence. Should house prices be kept artifically high keeping the imprudent, irrational horde in houses they should never have bought and keep prudent savers out? Is it good policy to tell people by our collective actions that it is ok to be irrational, ok to be foolish because if you mess up real bad, Uncle Sam will bail you out? Understand that bailing someone out doesn’t work for drug addicts and certainly won’t work for cheap money addicts.

I am not buying the sob stories. If these people were asked the direct, tough questions, I doubt they would earn as much pity. I feel equally unforgiving to firms. If Bear went under, it would have been a good lesson to their customers to perform better risk management. The answer is not new regulation, it is to make sure everyone knows that when they are foolish, they will pay. We are sending exactly the opposite message right now. The B&M crowd is certainly revved up to a fever pitch and nothing will stop them (so they think)…

Chris Grande

PS. Editor’s addition – 6.12.08 – They’re at it again – this time it is Lehman that might go down – will they be allowed to fail or do they get a fancy buy out package?

See HERE, HERE, and HERE for news and commentary on this.

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