Moral Hazard, the Subprime Market and the Nanny State

Foreclosures tick up a bit, and government officials are falling all over themselves to save people from themselves. Ohio is planning on issuing a $100 million bond to bail troubled borrowers out. See this article in USA Today for details. And now, Freddie and Fannie already under significant pressure for their financial shenanigans, are rolling out new products to deal with the fall out.

Fannie and Freddie innovating to help out is not as big an issue for me personally. Though, I suspect the political pressure being brought on them has something to do with it.

Here is where the moral hazard comes in though. If states like Ohio, or probably California soon, or even the Federal Government spend tax dollars to essentially bail out borrowers who made poor decisions, then what is the incentive for those borrowers or any borrowers to do their due diligence and make sure they can afford a home? There is none. This was not a failure of the private market. People made bad decisions, and companies made bad decisions in extending credit. The rush of politicians to shield people and companies from their poor decision is one step further down the road of infantalizing the populace.

This is bad from an economic standpoint because of the moral hazard, and how it distorts future market decisions, and even worse from a policy perspective because it reinforces the idea that the government is the answer to everything.

So, maybe next time, I have difficulty paying the bills, I'll send a request to my buddies in Washington, they can pay it for me. We can call it an earmark, after all, there's no reason I should starve because I spent too much money going to Vegas. (ed: is it possible to spend too little money in Vegas?)

Subprime (Again....)

Felix Salmon over at his new blog points an article at Bloomberg, which I hadn't noticed. Fremont General, a large-sized originator of "subprime" loans, has recently sold several chunks off at a loss. The latest was a $2.9 billion chunk of loans, while we don't know the explicit quality of these loans, we can make a few assumptions here. First, Fremont sold these at a $100 million discount. Do the math and that is an expected loss of about 3.45%. If we make the assumption that this particular chunk of loans is representative of the market, then the so-called meltdown in subprime is not something to feared, it'll hurt, but it is not the end of the world.

Also, I would point out, this how healthy financial markets work. They discount and work through the bad stuff. Just as we did after the S&L crisis. In the apartment market we are already seeing that, with reversions of condo-conversions happening, and some minor REO stuff on failed conversions. There is significant amounts of "vulture" capital waiting to make a play.

Watch the subprime market, but if Fremont General is any indication, it won't be as bad as some are prognosticating.

Chasing Yields

The more and more data that I look into, it becomes apparent that Fed Chairman Ben Bernanke may have been on to something with his notion of a liquidity "glut." I wouldn't use the term glut, because that implies an excess of what the market demands. I don't believe that is the case, as the supply of capital has shifted to the right in a traditional AD / AS framework, we would expect more investment at a lower interest rate. Let me fill you in on some of the research that I've done. First let me preface it with the conventional wisdom in Commercial Real Estate, which is that investors are chasing yields, and so are banks. This is true, low lending rates have driven down cap rates and in some cases, below lending rates, meaning the owners are what I call "momentum" investors. They are gambling that the market will appreciate. This is particularly evident in Southern California. Rule of thumb, anything below about a 6.25% cap based on actuals, is someone who is banking on momentum, or they are engaging in a redevelopment through conversion or rehab.

So back to the story, I am doing some research on India for my global macroeconomics class, and interestingly enough real yields on Indian debt have declined over the last several years. We can mark this off as coincidence, based on better management of inflation by the Central bank. Yet the key story is that inflation accelerated in 2006, from 3% to about 6% (according to the Economist Intelligence Unit), and interest rates did not respond. What was astounding to me, and this really connects into monetarism, is that the supply of M2 jumped from a growth rate in the teen, about 18% in 2005 if memory serves, to over 24% in 2006. Inflation up? Coincidence? I'll let you be judge. So, in India we have declining real rates of interest.

Across the small pond we call the Pacific Ocean, and across a few mountains, we come to lovely state of Texas. So how are India and Texas linked? From 1990 to 2002, gross nominal yields averaged about 17.5%. By 2006, those same yields had fallen to 11.6%. As they say, the plot thickens....